Canada’s Government Spending Helped Interest Rates Soar: BMO

Canada’s economy has been a raging inferno of excess demand, and policymakers are throwing gas on it. That was the take in a new BMO Capital Markets memo warning that Federal spending is outpacing the country’s economic output, contributing to excess demand and higher inflation. As a result, the bank warns that interest rates have had to climb much higher than expected, as monetary policy attempts to curb the issues created by fiscal policy.

Canada’s Federal Government Spending Is Outpacing Its GDP

Canada’s economy is outperforming expectations, but still getting state stimulus. Federal spending as a share of GDP remains at 15%, a point higher than pre-pandemic levels. According to BMO’s calculations, the 3-year average is 19% of GDP—nearly 6 points higher than the long-term mean. Not only has spending kept up with soaring GDP, it’s now surpassed its growth. 

Canadian Federal Government Spending As A Share of Nominal GDP

Source: BMO Capital Markets. 

Governments spending like drunken sailors isn’t exclusively a Federal issue, and seen at all levels. BMO warns the aggregate of all government spending is 38% of GDP, vs the trend of 37% pre-pandemic. The three-year average is 7 points above the long-term mean of 43% of GDP, according to their calculations. 

It may appear they’re paying for growth, but scaling with GDP already accounts for that. If Canada’s economy was already pushing its capacity limits, the additional stimulus turns into excess demand, and results in non-productive price growth—aka inflation. The excess demand stimulated by the government required higher interest rates to cool general borrowing. 

“It Didn’t Have To Be This Way”

Canada isn’t alone, with its neighbor to the south taking a similar path. The bank also observed higher levels of Federal government spending relative to GDP in the US. The stimulus driving excess demand is helping to fuel higher interest rates, with central banks attempting to use monetary policy to curb the spending. The Federal Reserve is expected to hike its key policy interest rate by another 25 basis points this month, hitting 5.25%-to-5.50%—the highest level in over a decade. 

“It didn’t have to be this intense, if fiscal policy had not run so far the other way.” Said Douglas Porter, a prominent economist at BMO Capital Markets 

Adding, “Overall, while monetary policy has been rowing hard to contain inflation, fiscal policy has been busily paddling in the opposite direction.” 

Typically governments spend to stimulate a slow economy, not one that’s outperforming. Considering Canada has been outperforming its G7 peers, it’s easy to see how adding fuel to that fire generated excess demand. Federal spending outgrowing the growth of Canada’s economic output has also been a trend that began before the pandemic, so it’s not entirely related to the recent global economic downturn.