Interest rates are 200 bps higher than they should be due to government spending: Scotiabank


Canadian interest rates are about 200 basis points higher than they otherwise would be due to government spending at all levels, including billions spent on pandemic relief.

That’s the assessment from a new Scotiabank report that set out to put an exact figure on the impact government spending has contributed to higher interest rates.

“There is no question in our minds that fiscal policy has complicated the task of monetary policy in Canada,” wrote the report’s authors, Jean-Francois Perrault and Rene Lalonde. “Interest rates are substantially higher than they would be had government consumption spending at all levels of government remained fixed in relation to GDP.”

They calculated that of the 475 basis points (4.75 percentage points) in Bank of Canada rate increases since last March, about 200 bps was needed to counter the impact of spending by all levels of government, along with the federal pandemic support programs.

“In other words, absent actions taken by all levels of government, the policy rate would need to be about 3%, at the high end of the Bank of Canada’s estimate of the neutral policy rate,” they said.

They said government spending has necessitated about 120 bps worth of Bank of Canada rate hikes—70 bps due to provincial spending decisions, 30 bps for federal and 20 bps at the municipal level—while the federal government’s COVID relief spending contributed another 80 bps to current monetary policy.

In April 2022, the Parliamentary Budget Officer released a report that found the federal government had spent or planned to spend $576 billion in new COVID-relief measures. In total, federal spending for the 2020-21 fiscal year topped $1.1 trillion, up $368 from the previous year.

Government spending was needed, but was “miscalibrated”

While the report doesn’t suggest that all of the spending was unnecessary, the authors do criticize government for both the amount of government spending and the size and duration of the pandemic relief measures.

“Some of the rise in government consumption of goods and services was likely desirable and necessary given population growth and ageing, but those expenditures were inconsistent with inflation control and led to higher interest rates,” they noted.

“Overall, our results suggest that fiscal policy was badly mis-calibrated since the pandemic from an inflation management perspective,” they added. “All levels of government are responsible for this.”

They acknowledged that additional spending was needed to ensure government services kept up with the population growth—which Scotiabank says has “exploded” in recent years—and the aging of the population.

While fiscal policy can be a “powerful tool” to combat negative economic shocks, the authors say it can also cause issues when too much fiscal support is provided, which they argue has been the case in Canada given that government spending has outpaced GDP since late 2019.

“There was nothing temporary about the surge in government consumption,” they wrote. “Pandemic transfers, on the other hand, were temporary but extremely large and kept in place too long.”

Perrault and Lalonde say a “number of mistakes were made on the monetary front,” by the Bank of Canada, but more so by fiscal authorities at all levels of government.

“We quite literally cannot afford to repeat these errors in upcoming budgets,” they added.

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