With inflation running at 6 percent and a federal debt of around half a trillion dollars over two years, Canadian macroeconomic policy is a mess. It will get worse. The Bank of Canada is moving to reduce inflation by applying the brakes. This week’s federal government budget will show tens of billions more in borrowing and spending, with its foot firmly on the gas. Monetary tightening and fiscal excess foreshadow a wild economic ride ahead. Perhaps a recession.
Saying “recession” may seem alarmist. The economy is in a tear. Employment is well above and unemployment well below where they were before COVID. Spending across the economy rose an astonishing 12 percent over the past year.
The problem, however, is that this increase owes a lot to the Bank of Canada and the federal government stepping on the gas. Labor shortage measures are at all-time highs. Three-quarters of that 12 percent increase in spending reflected not real growth, but higher prices. Our economy is over the speed limit.
The problem with monetary policy is more obvious. Partly because the results of excess money show up faster. Inflation well above the Bank of Canada’s 2 percent target is right in our faces every time we fill up our cars, visit the grocery store and pay our bills. And partly because the central bank admits it was wrong. Bank officials warn that interest rates may rise higher and faster than people expected.
The problem with fiscal policy is less obvious. A larger government gradually crowds out private activity. Compound interest payments have not yet squeezed the rest of the federal budget. Also, unlike the Bank of Canada, the federal government still says everything is fine.
Deficits were a hallmark of government policy even before COVID-19 set the stage for unprecedented borrowing with an equally unprecedented lack of accountability, not even a budget in 2020. Concerns about runaway finances led to the Minister of Finance, in his Fall Economic Declaration of that year, to describe indicators – “fiscal guardrails” – that would trigger a return to fiscal prudence. At the time of the 2021 update, the economy was clearly at or past them. But that update said nothing about guardrails or caution. Since then, we have had significant new program commitments, mostly financed with more debt.
Meanwhile, the government going full throttle is squeezing the rest of the economy. Public sector employment increased 8 percent from before the pandemic; It’s no wonder companies have trouble hiring. With no slack in the economy, consumption is crowding out private investment. The stock of commercial plant, equipment, and intellectual property products per worker is falling.
That brings us back to monetary policy. The Bank of Canada itself now highlights that low business investment means weak growth in productive capacity. And weak growth in productive capacity means that less of each additional dollar of debt-driven spending induces real output, and more induces higher prices.
The resulting rise in inflation has taken everyone by surprise. Until now, the bank has only touched the brake. Even after a quarter-point increase in February, the bank’s policy rate is more than four percentage points below the rate of inflation. It may need to be raised that high to cool things down. With the US Federal Reserve also signaling that it is ready to hit the brakes, concerns are mounting about a slowdown or worse.
As for fiscal policy, higher interest rates will increase the cost of servicing the rapidly growing federal government’s debt, even as declining growth curbs its revenues. It will take its foot off the gas, and if interest rates and concerns about mounting debt become dire enough, it may hit the brakes. Another reason why a crash, a recession sometime in the next two years, is a serious prospect.
To improve our chances of safely navigating the economic path in the years to come, the federal government must recognize that its spending and borrowing have outpaced the Canadian economy and are making us vulnerable. You need to release the throttle, which, in turn, will allow the Bank of Canada to release the brake. The feds’ foot on the accelerator and the bank’s foot on the brake are leading us toward a breakdown.
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