Opinion: The government can do more to help the Bank of Canada fight inflation – or at least stop holding it back

With inflation raging at levels not seen in more than 30 years, attention has turned to the different ways the Bank of Canada and the government might contribute to taming it.

Specifically, it has been suggested that the government, which continues to pump spending at an exponential rate, has been somewhat south of helping in this regard. This is true, although perhaps not quite in the way it was presented.

The Bank’s contribution is relatively direct. If money becomes very cheap and abundant, this makes it more expensive and rarer. Hence the recent sharp hikes in interest rates, along with the gradual rollback of the government bond-buying program initiated during the pandemic.

This, however, is the easy part. No one should doubt that the bank can bring inflation back to the 2 percent range which is its target. The only question is how long it will take, and at what cost. That will depend, crucially, on how high rates of inflation people think will persist, and for how long: on inflation expectations, the phrase says.

If people believe that when the bank says inflation will soon fall to 2 per cent, they will adjust their wages and price requirements accordingly. On the other hand, if they expect persistent high inflation, it will take a harsher and longer-lasting dose of monetary tightening to convince them. Or, in other words, stagnation.

The bank’s other main task, then, is clear: it’s to scare people. If people think the bank is so serious about curbing inflation that it is willing to risk a recession to do so, they are more likely to adjust their demands before the actual event. It’s true: the more people anticipate a recession, the less likely we are to experience a recession.

This is the “tough bastard” theory of monetary policy. Unfortunately, today’s generation of central bankers have been at some pain until recently persuading people that they weren’t as tough as all that – that they were just as concerned with inclusion, climate change, and other good causes.

Well, listen to them now. Sharp interest rate hikes recently have been accompanied by sharper rhetoric. The Bank of Canada promises to act “more aggressively” in the future if necessary. The Federal Reserve promises more “pain” ahead. Each speaks of its unilateral determination to reduce inflation. He doesn’t talk about anything else.

What is the government’s role in all of this? Mostly, it is to stay out of the way: not to do anything that would undermine the bank’s credibility, or hinder its efforts. In this lenient task largely failed.

There are three things the government can do. The first is to support the Bank of Canada to the fullest: to make it clear that when the Bank pledges to do whatever it takes to bring down inflation, it has the full support of the government. Yes, she does that now. But it was only last fall that so many extraneous phrases were introduced into the bank’s mandate, at the behest of the government itself.

Second, it can control its spending. As we’ve seen, that wasn’t imminent. This is sometimes presented as if government spending itself was helping to raise inflation. But it is not clear whether fiscal policy in a small and open economy has this kind of effect on prices, more than on real production.

Government spending is more likely to affect the formation of demand than the level. Only if the central bank absorbs this spending, i.e., by making more money available, it leads to more spending in the aggregate. Otherwise it only leads to crowding out private spending.

Which is what is happening now. As a recent report by Bank of Nova Scotia economists made clear, if public spending cannot be reduced, private spending must be reduced further (“Production losses that the Bank of Canada must engineer to rein in inflation fall disproportionately on the private sector.” ‘), by higher rates of interest than would otherwise be required.

Third, the government can implement measures to improve the efficiency and resilience of the economy – its ability to provide goods and services in line with demand. The more dynamic the “supply side” response, the more a given increase in demand will translate into higher production, rather than higher prices – the less production will contract, in the opposite direction.

The government only recently started talking about this. It’s a start. But it will have to support this much more in the way of politics if it is to be seen as an aid, rather than a hindrance, in the fight against inflation.

Keep your opinions sharp and informed. Get the newsletter. Register today.

Leave a Comment