This text is taken from the Courrier de l’économie of November 8, 2022. To subscribe, click here.
In the current fight against inflation triggered by a contraction in supply, what is the probability that a restrictive monetary policy (rise in key rates) will be effective? asks a reader, Éric Deland. For Quebec, is it not contradictory to adopt an expansive fiscal policy (reduction of taxes) in the face of the restrictive monetary policy of the Bank of Canada?
The current inflationary spike is not just a supply shock story. The Bank of Canada also insists on the presence of excess demand in the economy, the impact of which on the rise in prices is amplified by this firmly anchored supply shock, in particular under the weight of distortions in the supply chains. supply.
Added to this are the economic repercussions of Vladimir Putin’s war against Ukraine in the form of rising energy and food prices. Not to mention the impact of persistent tensions on a labor market under the influence of a labor shortage.
This combination of excess demand shock supply involving a range of exogenous variables mitigates the impact of a rise in the cost of money which, to compensate, must be stronger and more convincing.
The Bank of Canada also has to deal with one of the most interest-sensitive economies in the G20. It must maneuver in a context of high household debt and real estate exuberance. By raising its interest rates, it aims to put pressure on demand, and therefore on household spending, and on business investment. With the aim of restoring a balance between supply and demand which will reduce the pressure on prices. It also wants to avoid an unanchoring of long-term inflationary expectations that could lead to a wage-price spiral.
The rise in interest rates, which plays on demand and by extension on supply, remains the best tool, the scope of which is increased by quantitative tightening, which consists of removing from its balance sheet government bond securities purchased during of the health crisis.
Finally, an increase in production costs, transferred in part or in full to consumers, means that they will be less willing to buy as many goods and services, which will push companies to reduce their production. All this while waiting for distortions in supply chains to resolve.
In terms of governments’ contribution to the fight against off-target inflation, their fiscal policy must be consistent with monetary austerity. It must include timely and targeted interventions to address vulnerabilities without thwarting the efforts of central banks.
The International Monetary Fund has insisted more than once: “In the face of long-lasting supply shocks and widespread inflation, attempts to limit price increases through price regulation, subsidies or tax cuts will be costly for the budget and, ultimately, inefficient. Authorities should let prices adjust and temporarily provide targeted cash transfers to [agents économiques] the most vulnerable. » What economic history teaches.
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