Assessing the Bank of Canada’s Inflation Surge Fight

A low and stable inflation rate environment promotes economic efficiency and fairness. And since the early 1990s the Bank of Canada’s monetary policy framework has included a 2-percent inflation target in a 1 to 3-percent control range.

Since inflation targeting was adopted in the early 1990s, the consumer price index (CPI) remained within the control range most of the time. Departures, when they occurred, were relatively modest and brief. At least until recently.

While inflation remained subdued in 2020 as the full impact of the COVID-19 pandemic hit Canada, it began to accelerate suddenly in the spring of 2021, breaking through the Bank’s control range in April and ultimately peaking at 8.1 percent in June 2022. It fell back within the control range last year and today sits near the target rate.

Despite the “transitory” nature of the inflation surge, there has been a permanent shift upward in the price level path, because the inflation-targeting framework allows bygones to be bygones – there is no matching below-target inflation to compensate for above-target periods.

Could the Bank of Canada have prevented this?

In our new C.D. Howe Institute paper, we argue that the fiscal responses to the pandemic were primarily responsible for the 2021-22 inflation surge, and that there was little the Bank of Canada could have done.

Our view is based on the following premises.

First, fiscal policy plays a critical role in determining both the price level and the long-run rate of inflation.

Second, emergency fiscal transfers can be viewed as either funded (backed by future austerity measures) or unfunded. Unfunded fiscal transfers function as “helicopter drops” of money directly to the private sector.

Third, at full employment, for a given interest rate structure, injecting nominal wealth leads to a temporary burst of inflation and a permanently higher price level.

Fourth, as long as inflation expectations remain anchored, central bank interest rate policy can at most influence the inflation dynamic – not the total amount of inflation ultimately realized.

Normally, a central bank can ignore fiscal policy, or government spending, in pursuing its mandates. However, this can change during major national emergencies – such as unexpected wars or pandemics – when large-scale fiscal expenditures are required.

In these events, an unexpected increase in the price level (a short-term increase in the rate of inflation) can both lower the inflation-adjusted cost of capital for financially strained firms and the real debt burden for the government. 

Interest rate policy aimed at curbing inflation in these situations may be counterproductive.

Viewed in this light, criticism that the Bank of Canada was slow to react may be off the mark. Given the nature of the crisis and the fiscal response, discouraging the inflation surge would have inhibited economic recovery and worsened the fiscal burden.

In a national emergency, and in particular when large fiscal outlays are necessary, it may be desirable for monetary policymakers to accept a significant, albeit temporary, departure from their inflation target. After all, government outlays need to be financed one way or another – someone needs to pay. The only questions are who, how, and when.

There is little reason, in either experience or theory, for ruling out the use of a temporary inflation tax in advance, especially when compared to temporary increases in other tax rates or interest rates, which would have imposed costs in other areas.

Setting aside what may be desirable, there is also the question of feasibility. If a large injection of government securities is not expected to be “funded” (i.e., if fiscal policy is temporarily unanchored), it is unclear how interest rate policy alone could sustainably contain inflationary pressures driven by fiscal actions. Without fiscal support, raising the interest rate only serves to delay an inevitable inflation surge.

To conclude, seen through the lens of optimal public finance, the 2021-22 inflation surge in Canada could be viewed less as a policy mistake and more as an unintentional – though ultimately desirable (given the circumstances) – manner of financing the transfers that were deemed necessary in the COVID-19 crisis.

The monetary policy mistake, in our view, had more to do with a failure to communicate the considerations described above (and in Andolfatto 2020). In any case, and somewhat paradoxically, this experience may have helped reinforce to Canadians the importance of a central bank that targets low and stable inflation.

The COVID-19 crisis will not be the last emergency Canada faces. The question of optimal monetary-fiscal policy coordination in anticipation of the next crisis should be placed on the agenda for the upcoming review of the Bank of Canada’s monetary policy framework. Along with transparency about targets and intentions, the expected interplay between monetary and fiscal policy in a crisis needs to be spelled out clearly beforehand, with full parliamentary support.

David Andolfatto is a Professor and Chair of the Economics Department in the Miami Herbert Business School at the University of Miami. Fernando M. Martin is senior economic policy advisor in the Research division of the Federal Reserve Bank of St. Louis