On Inflation, QE, and Canada’s Fiscal Deficit

Given the recent unprecedented actions taken by both the Government of Canada and the Bank of Canada in response to the pandemic, it is understandable that investors are beginning to ask serious questions about the potential economic ramifications of the government’s recent large-scale rescue package. Of chief concern appears to be the belief that the Government of Canada, aided by the Bank of Canada, has effected both an unsustainable increase in the national debt as well as a large injection of new money into the economy which is destined to fuel future inflation.

With respect to inflation, one of the concerns often raised is the Bank of Canada’s foray into Quantitative Easing (or QE, for short), in which it purchases Government of Canada bonds from the private banking sector in exchange for newly-created bank reserves. It is unnecessary to wade into the details of whether QE actually constitutes “printing money”, as the answer is somewhat technical and ultimately unimportant to the final conclusion. What is important is that the operation results in no increase in financial net wealth for the private sector, and therefore no potential increase in spending. Where the private sector before owned a bond, they now have cash. They may indeed decide to redeploy this cash into financial markets, which may have the effect of driving up asset prices further, but because the private sector is not any wealthier as a result of the operation, they are no more likely to spend this injection of wealth on goods and services. Furthermore, the inability of QE to increase general prices is also the conclusion drawn from the real-world experience of QE in the US and other developed countries.

The second concern often raised is that the Bank of Canada is directly financing the government deficit, in the sense that the Bank of Canada has been purchasing newly issued bonds from the government in exchange for newly created money deposited in the Government of Canada’s account at the Bank of Canada. While the Bank of Canada has been purchasing T-Bills at an unprecedented rate, we know from an examination of the Bank of Canada’s balance sheet that government deposit balances created by the Bank of Canada were simply allowed to pile up and have not been “spent” into the broad economy. In fact, as the treasury bills that the Bank of Canada holds have been maturing, government deposits at the Bank of Canada have been similarly decreasing. We are therefore led to the conclusion that while the Bank of Canada created large amounts of money for the government, this money was never spent and is currently being unwound (destroyed) as of the time of this writing. This is because Bank of Canada purchases of government debt was primarily used to support bond prices and lower interest rates, not to finance government deficit spending. This operation was therefore also benign from an inflationary sense.

Third, the concern over large deficits causing inflation is potentially a valid one. When the government runs a deficit, they borrow money from the private sector, giving the private sector a bond in exchange for cash. This operation initially leaves the net financial wealth of the private sector unchanged. When the government then spends or transfers these borrowed funds to the private sector, it serves to increase private sector net wealth by an amount equal to the government’s deficit spending. This increase in private sector financial wealth represents an increase in the potential claims on real wealth in the economy. In other words, if the private sector seeks to spend their newfound financial wealth on real goods and services, it may serve to bid up prices in the overall economy. Given the current economic uncertainty, however, the general public has clearly chosen not to spend the entirety of the newly injected money, rendering inflation tame. Ultimately, however, whether or not significant inflation occurs depends on the tendency of the private sector to spend or not spend their accumulated wealth, and the rate of growth of “real” wealth over time (ie. the growth rate of goods and services). If the economy grows significantly as a result of increased government spending, the amount of real things in the economy being bid on will also increase, and inflation may not materialize even as the private sector seeks to spend a portion of the injected wealth. It is highly debatable, however, whether government spending in response to COVID has done anything to increase future productivity and output.

Fourth, with respect to the deficit, it is important to remember that for a country like Canada, which issues its own currency, the debt is always “affordable” in a nominal sense. The Bank of Canada can work with the government to set borrowing costs at practically zero, or merely print the money if push came to shove. The real danger is that the economy simply cannot absorb all of the increased spending that occurs from large scale deficits, resulting in high inflation as the private sector attempts to spend their increasing financial wealth on a relatively smaller pool of real wealth. In this case, to tame inflation, either the Bank of Canada would need to dramatically increase interest rates to incentivize the hoarding of wealth over spending, or the government would need to run a surplus to remove financial wealth from the private sector. Both increased taxation on existing wealth holders and significantly higher interest rates would undoubtedly negatively impact many Canadians with significant financial assets.

Because it is ultimately unknown whether inflation or disinflation will be the obvious outcome, and because policy responses are uncertain, it likely makes little sense for investors to deviate from their long-term financial plans in reaction to the current economic situation. Generally speaking, sitting still and doing nothing is par for the course during market turmoil, provided of course that investors are happy with their overall risk exposure. For those investors who have found their current asset allocation has provided more volatility than they are comfortable with, they may wish to look into less-volatile “all-weather” portfolios which seek robustness amidst a variety of different economic conditions.