One of Bay Street’s top economists estimates that the Bank of Canada’s benchmark interest rate is headed to 4.25 per cent, and more than a percentage point of the increase will have been necessitated by a need to offset “excess demand” created by what appears to have been overly generous COVID benefits.

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'Exaggerated' pandemic benefits fuelled 'excess demand,' driving steeper rate hikes: Scotiabank Back to video

“Pandemic support programs for firms and households are creating the excess demand that the country is experiencing,” Bank of Nova Scotia chief economist Jean-François Perrault concludes in a new assessment of Canada’s inflation scare, published Dec. 5. “Absent from these support measures, Canada would still be in excess supply.”

By “excess supply,” Perrault, a former assistant deputy minister at the Finance Department, means the economy would be weaker than it is today: suppliers of goods and services wouldn’t be struggling to fill orders as they have been for much of the year, and there would be less upward pressure on inflation.

The thrust of the Scotiabank report was to assess what’s driving inflation, not pass judgement on Ottawa’s response to the COVID recession. Perrault and and his co-author, René Lalonde, the bank’s director of modelling and forecasting, wrote that the main fiscal rescue programs — the Canada Emergency Response Benefit (CERB) and its successor benefit, the Canada Recovery Benefit (CRB), along with Canada Emergency Wage Subsidy — had a “large and welcome impact on the economy,” as an extraordinary economic collapse was followed by the engineering of an equally extraordinary recovery.

Still, with hindsight, they said Ottawa’s response was “likely exaggerated,” and the “inflationary impulse” created by that spending is what Bank of Canada governor Tiff Macklem is now trying to offset with the most aggressive series of interest-rate increases since the central bank began targeting inflation in the 1990s.

“The Bank of Canada’s policy rate would not need to be above neutral were it not for these programs,” Perrault and Lalonde wrote.

The neutral rate is the theoretical rate at which the central bank and economists estimate that borrowing costs would be neither impeding nor encouraging economic growth. The Bank of Canada estimates the neutral rate is between two per cent and three per cent, and the Bank of Nova Scotia’s economics team puts the rate at 2.5 per cent.

In other words, if Prime Minister Justin Trudeau had ended his rescue programs sooner, or made them less generous, interest rates probably would be lower, according to Perrault and Lalonde, who used their in-house economic model to produce an estimate on the main sources of inflation.

They found that half of the upward pressure on prices since the end of 2019 was the result of global factors over which the central bank has little or no control, including U.S. inflation, commodity prices and a weaker exchange rate. And they found that supply constraints caused by the pandemic explain another 35 per cent of the increase in prices.

The Bank of Canada’s policy rate would not need to be above neutral were it not for these programs

That means purely domestic factors such as the pandemic programs account for a relatively small amount of the inflation, but they had a “major impact” on the “output gap,” a concept that the Bank of Canada uses to take the temperature of the economy, as it measures the difference between policymakers’ estimate of the value of all goods and services the economy can produce without stoking inflation, and the actual level of economic output.

The CERB, which was swiftly put in place in March 2020 to provide $2,000 in monthly payments to Canadians who lost income from the pandemic; the wage subsidy, which supported employers; the CRB; and the Canada Rent Relief Program all helped the one million Canadians who lost their jobs during the onset of the pandemic, as well as many more struggling with shelter costs and running their businesses.

Those programs pushed tens of billions of dollars into the economy, lifting the output gap by 1.3 percentage points alone, according to the Scoitabank study. It’s the demand generated by that spending that the Bank of Canada is now trying to offset with higher interest rates, Perrault and Lalonde concluded.

The recovery had lots of momentum by the end of 2021, suggesting rescue programs could have been wound up. The CRB ended on Dec. 23, 2021, and the last of the pandemic-era supports, the Canada Recovery Caregiving Benefit (CRCB) and the Canada Recovery Sickness Benefit (CRSB), concluded on May 7, 2022.

While there’s little Macklem can do about the global drivers of inflation, interest-rate policy has considerable influence over domestic demand. If not for the excess demand stoked by the COVID rescues, Perrault and Lalonde estimate that the Bank of Canada could have stopped raising interest rates when the benchmark reached 2.5 per cent.

The target rate is currently at 3.75 per cent, and Scotiabank’s economics team predicts Macklem will lift borrowing costs to 4.25 per cent when he and his deputies conclude their latest round of deliberations on Dec. 7.

Scotiabank expects a gradual decline in the pace of inflation over the next year to year and a half, averaging about 6.8 per cent for 2022. The team then expects inflation to fall to four per cent next year before returning to the Bank of Canada’s two per cent target in 2024. Scotia sees higher interest rates combining with weaker demand for exports from China and Europe combining to cause a “very mild recession, akin to a stall in growth” in the first half of 2023, followed by “very modest” growth over the rest of the year.

“Much of the reduction in inflation stems from a reversal of the global factors that have pushed inflation up in Canada and elsewhere,” Perrault and Lalonde said in the report. “These factors (largely commodity prices and supply bottlenecks) have mostly unwound the gains made over the last year and appear to be slowly working their way through to inflation. That is expected to continue.”

• Email: shughes@postmedia.com | Twitter: StephHughes95