The Bank of Canada has raised its key interest rate again, this time by one percentage point, the largest increase in 23 years. The bank’s governor warns that the policy rate will continue increasing until inflation has cooled down to around 2%.

When faced with inflation, these policy rate hikes are easy to justify. Indeed, job vacancies are at a record high and unemployment rates are very low in most regions of Canada. For the time being, economic growth is on track.

But will these policy rates succeed in curbing inflation? I doubt it.

The current inflation rate is a global phenomenon that mostly stems from supply issues. Current inflation is a supply problem, not a demand problem. While it is true that reducing domestic demand may slightly ease inflationary pressures as people spend less money, this strategy poses other risks. The most serious risk is that it could cause a recession, which would undermine the adjustment of supply chains — the root cause of inflation — and hinder the economic transition that we urgently need to counter climate change.

High interest rates disincentivize private investments that are crucial for restoring supply chains, especially in our global economy where uncertainties are increased. They also dissuade companies from adopting green technologies.

Nevertheless, governments can mitigate the risks of recession and stagnation from successive interest rate hikes.

If the goal of monetary policy is to restrict demand and ease inflationary pressures, then a sound fiscal policy must counter supply problems.

Such a fiscal policy must aim to increase investment — namely, public and private investment — that is needed to transition to a cleaner economy and achieve our country’s net-zero emissions targets.

Fiscal policy should also help ease the perverse effects and the inevitable consequence of increased interest rates on the most vulnerable.

However, when faced with higher interest rates, governments will likely feel pressured to cut public spending and social investments to reduce the deficits accumulated during the pandemic.

We have seen this scenario play out during the 1980s and 1990s, when interest rates were high and governments wanted to reduce debt. Canada struggled under economic stagnation and public underinvestment, the effects of which are still being felt today. We only need look at the state of our roads, our hospitals, our schools and more to see the evidence of this cost-cutting era. 

Yet, unlike the 1980s and 1990s, the unemployment rate will likely be lower this time around as more baby boomers retire. There may even be job vacancies in certain sectors, such as construction, health and education. Paradoxically, production could also decline, which would mean persistent supply issues and continued inflation problems. In such a pessimistic scenario, government deficits would increase. And pressures to balance budgets will resurface.

Canada’s finance minister and her provincial counterparts must not forget the 1980s and 1990s or give in to popular pressure to balance budgets in a hurry. Instead, they must develop investment plans and adopt rigorous budgets. All too often, budgets are political responses to the checklists of various groups. It is time for clear budgetary targets, tied to a fiscal anchor, that outline necessary social investments to help transition the economy to a clean and prosperous one.

To facilitate such a disciplined budgetary exercise, public accounting must be adapted to today's realities. We must redefine the notion of capital to include intangible investment in human capital. This echoes the words of Mark Carney, former governor of the Bank of Canada, when he proposed in his recent book that governments’ financial balance sheets should be used to balance short-term growth with long-term sustainable growth. He argues that it is important for governments to invest in public goods, such as training, and have long-term visions.

David Dodge, another former governor of the Bank of Canada, said in a recent appearance before the Senate Committee on Banking, Commerce and the Economy that governments should also invest more in training.

In short, in the coming months and years, we must not be distracted by speeches advocating the need to quickly return to a balanced budget. We must remember the past. We owe it to future generations.

Senator Diane Bellemare represents the senatorial division of Alma in Quebec. She is an economist and a member of the Senate Committee on Banking, Commerce and the Economy.

A version of this article appeared in the July 23, 2022 edition of Le Devoir (French only).

The Honourable Diane Bellemare retired from the Senate of Canada in October 2024. Visit the Library of Parliament's Parlinfo website to learn more about her work in Parliament.