Opinion: Fiscal and monetary policy need to work together
By Jeremy Kronick and Luba Petersen
Since starting its fight against inflation last March the Bank of Canada has been focused on little else. That is in stark contrast with many of the country’s finance ministers, who have raised spending and increased government hiring. Coordination between our monetary and fiscal authorities would make the Bank’s job a lot easier. Failing that, however, the Bank should continue do what is necessary to get inflation back to target.
The onset of the pandemic saw unprecedented coordination between fiscal and monetary authorities around the globe, including in this country. The Bank of Canada lowered its policy rate to its effective lower bound (0.25 per cent) and then turned to less conventional monetary policy like quantitative easing — buying up government bonds at longer maturities to lower interest rates across the yield curve. Ottawa injected hundreds of billions of dollars into the economy to help individuals forced to stay at home and businesses that had to shutter operations. Even our financial regulator, the Office of the Superintendent of Financial Institutions (OSFI), normally content to stay in the background, loosened rules to free up $300 billion in additional lending.
Although they succeeded in staving off far worse economic and financial outcomes than we ended up facing, our monetary and fiscal authorities were too slow to turn off the taps and, as a result, inflation has been well above target since early 2021. Beginning last spring, the Bank has moved aggressively to raise interest rates. The federal government, however, has sent more mixed signals, increasing its spending as the Bank raised rates.
The obvious danger when fiscal policy steps on the gas even as the Bank is applying the brakes is that the Bank will have to hit the brakes even harder, which raises the cost of servicing governments’ — and everyone else’s — debt. This situation can easily spiral. If people are forward-looking and aware of the policy conflict, they will come to expect higher inflation. But expectations of higher inflation can quickly become self-fulfilling and damage central bank credibility.
The best thing for the fight against inflation would be for fiscal authorities to stop their new spending. But what if they don’t? What should the Bank of Canada do then?
In a recent paper, we studied just how forward-looking people actually are when the economy is coming out of a recession. Using methods from experimental and behavioural economics, we brought university students from diverse backgrounds into a laboratory economy and tasked them with making incentivized forecasts about inflation and output when their central bank and government’s policies were either coordinated or in conflict.
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We found that how people think about the future state of the economy does not depend much on the nature of policy coordination. Even in a very simple laboratory environment, our participants had difficulty considering how future interest rates and taxes — together with the debt level — would impact the economy. Rather, their expectations about inflation and the economy were mostly driven by the recent history of both. What this means is that both fiscal and monetary authorities would best manage expectations by keeping inflation low and stable. For the Bank of Canada, that means taking an aggressive stance on inflation no matter what governments are doing. That is what we are seeing today, and it’s the right approach.
These results matter at other times, too. Low inflation in the years between the financial crisis and the pandemic led many central banks to consider different monetary policy frameworks. For example, in 2020 the U.S. Federal Reserve switched to targeting average inflation — making up for any undershooting in inflation with future overshooting. The Bank of Canada considered a similar framework in its recent mandate renewal but opted against it.
The idea behind averaging in this way is that it will create better-anchored inflation expectations around the two per cent target. But for that to work people must be forward-looking and, for example, anticipate three per cent inflation next period if inflation is one per cent this period. But if, as our experimental results suggest, people use recent inflation experiences to formulate their outlook for the future, this make-up strategy will not work. Instead (in this example) expectations would get anchored at one per cent.
There are many policy lessons from the pandemic and the response to it. One is the success of policy coordination. Another is that people tend to use what’s currently happening to predict what will happen. With that in mind: in the absence policy coordination the Bank should continue to do whatever it takes to bring inflation back down to target.
Jeremy Kronick is director of monetary and financial services research at the C.D. Howe Institute. Luba Petersen is an associate professor of economics at Simon Fraser University.