Canadian Interest Rates 2 Points Higher Due To Gov Spending: Scotiabank

Canadian policymakers have been spending like drunken sailors, and it’s going to cost households. Not just in the form of taxes and service reductions, but on their mortgage too. A new analysis from Scotiabank looked at just how much government spending drove inflation, and thus interest rates. They estimate the Bank of Canada (BoC) overnight rate is a whopping 2 points higher due to the spending, primarily driven by the provinces.

Excess Demand Produces Higher Interest Rates

The central bank’s primary role is to maintain stable inflation, and they do it with interest rates. If consumption is too low, the central bank cuts rates to stimulate borrowing and demand. The goal is to intentionally overrun supply, since printing credit is much faster than supply chains responding. If successful, prices make a non-productive increase we call inflation. 

When inflation is too high the central bank will do the opposite. The overnight rate is raised to de-motivate borrowing, lower leverage and lower demand. The goal is to lower demand faster than supply chains can respond, resulting in a reduction in price growth. This is a little more tricky than creating inflation, since it takes longer to convince people cheap money isn’t right around the corner. 

All of this breaks if a government and its central bank aren’t on the same page. That’s exactly what happened towards the end of the pandemic. 

Government Spending Drove Interest Rates 2 Points Higher

A combination of spending and transfers to households helped produce excess consumption. Scotiabank estimates 200 basis points (bps), or 2 points, of the 475 bps increase to the overnight rate was due to government spending. They found that government consumption has outpaced gross domestic product (GDP) significantly since 2019. It doesn’t exactly look like a smart decision, since it’s failing to drive the growth one expects. 

One point in the bank’s analysis that may surprise—it’s not just the Federal government. In fact, their analysis shows the Federal government’s spending is just a small part of it. They attribute most of the state-driven share of interest rate hikes to provincial spending, representing nearly a third of total hikes. 

Governments Need To Spend, But How Much & Where Is Debatable

The analysis isn’t just the rantings of a libertarian bank economist, arguing spending wasn’t needed. They point to Canada’s rapid population growth as one factor requiring significantly more spending, since spending should scale alongside population.

“Combined with an ageing population, the needs for government services have risen dramatically,” explains Jean-François Perrault, Scotiabank’s chief economist. 

However, he believes this spending should be closer to GDP. His math reveals if the spending was restricted to just household transfers, it wouldn’t have been as inflationary.  

Even though governments borrowed at incredibly low rates, the amount is simply staggering. Even secured with low rates, debt servicing fees now represent a significant share of government budgets. The bank warns that failing to recognize this and repeating the error can be extremely bad news for households. 

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