December 6, 2022 – Canada’s monetary and fiscal authorities were highly coordinated through the onset of COVID-19. Since April 2021, however, inflation has far exceeded the top end of the Bank of Canada’s inflation target range – and the Bank is now sharply tightening monetary policy, while the federal government has increased new spending.
When policy coordination is uncertain, as it is today, the Bank of Canada should carry the ball in the inflation fight with interest rate hikes, according to a new C.D. Howe Institute report. “Amid fiscal uncertainty, the Bank of Canada is right to fight inflation alone,” says co-author Jeremy Kronick, the C.D. Howe Institute’s Director of Monetary and Financial Services Research.
In “Crossed Wires: Does Fiscal and Monetary Policy Coordination Matter?” authors Kronick and Luba Petersen examine how these authorities’ interactions, whether in conflict or coordination, at different points in a cycle (e.g. recession or recovery) affect economic outcomes.
Typically, economic theory holds that government fiscal policy and the Bank’s monetary policy work best in coordination. However, in inflationary times, problems arise when the government continues to increase spending and accumulate debt, which fuels inflation, on one hand, while the central bank raises rates to lower inflation, on the other – causing the servicing cost of debt to rise, dampening economic recovery and potentially causing a double-dip recession.
To explore the role of inflation expectations in policy coordination and conflict scenarios, Kronick and Petersen conducted a lab experiment where undergraduate participants from diverse disciplines interacted in a simulation economy, making predictions about future macroeconomic outcomes by playing the role of professional forecasters. Focused on the scenario of an economy in the middle of a recession with the expectation that it is headed for an economic recovery with excess demand, the authors find people are not as forward looking as models assume.
“The primary policy conclusion from our experiment is that people do not exhibit sufficiently forward-looking behaviour for expectations of future policy conflict to matter,” says Petersen, a Simon Fraser University Associate Professor of Economics. “We observe that people respond to the recent state of the economy and not on how fiscal and monetary authorities will react at some future moment in time.”
She adds: “It’s because people are mostly backward looking that the central bank should not stop the necessary interest rate hikes to tame inflation. By aggressively trying to keep inflation under control, it prevents extrapolative expectations from getting out of hand.”
For policymakers what is most important, say the authors, is not allowing a recession to become too severe or inflation expectations to become unanchored. Thus, acting quickly and decisively, and seeing results, is critical for economic stability.
“Ideally, with the Bank firmly in a tightening cycle to get inflation under control, governments would contribute to this fight by not adding new spending. This would help achieve those necessary results,” says Kronick. “However, should this not be the path fiscal authorities choose, while conflict makes things harder, our results suggest that the optimal path for the Bank of Canada is to continue its tightening cycle to get inflation back under control.”
For more information contact: Jeremy M. Kronick, Director, Monetary and Financial Services Research, C.D. Howe Institute; Luba Petersen, Associate Professor, Department of Economics, Simon Fraser University; and Lauren Malyk, Communications Officer, C.D. Howe Institute, 416-865-1904 Ext. 0247, lmalyk@cdhowe.org
The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.