Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Structural Budget Deficits
Transcript
- Lucas: When central banks talk about the economy, they usually focus on the output gap, inflation expectations, the neutral rate. But there's another number sitting on their dashboard that doesn't get nearly enough attention, and it's not even a monetary policy variable — it's the government's structural budget deficit. Luna: Structural deficit — meaning the part of the deficit that isn't just because the economy is running below potential, right? Lucas: Exactly. A regular deficit can be cyclical — tax revenues fall and welfare spending rises automatically when the economy slows. But the structural deficit is the underlying fiscal stance: how much the government is spending or taxing relative to what it would at full employment. It's the part of the budget that doesn't go away when the economy recovers. Luna: And central banks care about that because if the structural deficit is large, the government is essentially pumping stimulus into the economy even when it doesn't need it. Lucas: Precisely. That persistent demand injection can push up inflation, or at least put upward pressure on the neutral rate of interest — the rate where monetary policy is neither stimulating nor restraining. And that matters for where central banks actually set policy rates. Luna: So let's get concrete. What's a recent example where this has played out? Lucas: Canada is actually a great case study. The federal budget for fiscal year 2024–2025, tabled in April 2024, projected a deficit of about $40 billion Canadian. But the Parliamentary Budget Officer, the independent fiscal watchdog, estimated that the cyclically adjusted deficit — the structural part — was closer to $25 billion. That's a big number relative to the size of the economy. Luna: And this was at a time when the Bank of Canada was holding its policy rate at five percent, trying to cool inflation down to the two percent target. Lucas: Right. So you've got monetary policy pulling in one direction — high interest rates pulling down demand — and fiscal policy, through that structural deficit, injecting demand. Economists call this a 'fiscal-monetary mix' issue. The Bank of Canada's own research has shown that a persistently high structural deficit can push up the neutral rate by maybe 50 to 100 basis points. Luna: That's huge. It means the Bank's five percent rate might actually be less restrictive than it looks because the fiscal side is doing the opposite. Lucas: Exactly. And you can see this in the Bank of Canada's communications. In their Monetary Policy Reports, they started including a box on the 'fiscal path' — they literally spell out the government's planned spending and how it feeds into their GDP and inflation forecasts. That's a direct acknowledgment that the structural deficit is a variable they have to model. Luna: But isn't it always there? Governments almost always run deficits. What changed? Lucas: Two things. First, the post-pandemic deficits were huge, but they were also temporary — emergency spending that faded. The concern now is that the structural deficit has become entrenched: new permanent spending programs, tax changes that aren't revenue-neutral. Second, with debt to gdp ratios much higher than before 2020, the sensitivity of the economy to fiscal deficits might be larger. Markets start to worry about fiscal sustainability, which can show up in bond yields and feed through to the whole curve. Luna: So the bond market is the transmission mechanism. If investors think the deficit is too large, they demand higher yields, which tightens financial conditions — exactly what the central bank is trying to do manually. Lucas: And that creates a feedback loop. The Bank of Canada might not have to raise rates as much if the bond market does the work for them. But it also means that when the Bank does cut rates, fiscal dominance could complicate things: a rate cut stimulates demand further, but if the deficit is still large, inflation might not fall as fast. Luna: This is why I think the structural deficit concept is so important for listeners to understand. It's not just an accounting abstract — it directly affects whether your mortgage rate goes up or down. Lucas: Exactly. And the Bank of Canada isn't alone. The European Central Bank, the Bank of England, the Federal Reserve — all of them pay attention to cyclically adjusted budget balances from their respective fiscal watchdogs. In the US, the Congressional Budget Office publishes a standardized measure that strips out the effects of the business cycle. Luna: Let's talk about that. What did the CBO say recently about the US structural deficit? Lucas: As of mid-2026, the CBO's baseline projects a federal deficit of roughly $1.5 trillion for fiscal year 2026 — about five and a half percent of GDP. And their estimates suggest that a large chunk of that is structural: even if the economy were at full employment, the deficit would still be around four percent of GDP. That's unusually high for a period of low unemployment. Luna: And the Fed's reaction? We've heard Chair Powell mention 'fiscal sustainability' in press conferences, but it's never been a primary driver. Lucas: It's more indirect. The Fed's Summary of Economic Projections includes a long-run federal funds rate estimate — the neutral rate — and that has crept up over the past two years. Some of that might reflect higher structural deficits feeding into higher neutral rates. Powell has said the Fed doesn't 'coordinate' with fiscal policy, but they have to take the fiscal path as given. If the government is running a large structural deficit, the Fed has to account for that extra demand. Luna: So it's a constraint. The Fed can't set rates in a vacuum. Lucas: And it cuts both ways. If a government announces a credible fiscal consolidation — reducing the structural deficit — that can effectively do some of the central bank's work, allowing rates to be lower than they otherwise would be. That's what happened in Canada in the mid-1990s: the government brought deficits down sharply, and the Bank of Canada was able to cut rates more aggressively. Luna: But we're not seeing that now. Instead, many advanced economies are running persistent structural deficits, and central banks are left to clean up. Lucas: One of the reasons is that the fiscal rules that existed before the pandemic — like the EU's Stability and Growth Pact — have been suspended or reformed, and countries are taking time to return to fiscal discipline. The UK had a mini-budget crisis in 2022 precisely because markets reacted to a large, unfunded structural loosening. Luna: And that's a cautionary tale. When markets lose confidence in fiscal sustainability, the central bank can't just paper over it. Lucas: Right. The Bank of England had to intervene in the gilt market to restore order, which was a very uncomfortable position for a central bank to be in. It blurs the line between monetary and fiscal policy. Luna: So what should listeners take away from this? If they hear their central bank governor mention the 'fiscal stance' or the 'cyclically adjusted deficit,' they should know that's a signal. Lucas: Absolutely. It means the central bank is trying to estimate how much of the economic push is coming from government policy versus private sector demand. And it influences their rate path. If you're an investor, or even just someone with a variable-rate mortgage, that's worth paying attention to. Luna: And speaking of paying attention — if you've found our deep dives into central banking useful, we just want to mention something quickly. Lucas: Yeah. You know, we keep this show free and without ads because we believe clear economic explanations should be accessible. And that's only possible thanks to listeners who choose to support us. Luna: If walking through the economy with us has made something click, you can help keep the episodes coming by visiting buy me a coffee dot com slash fexingo. No pressure, genuinely — but every bit helps us keep doing this. Lucas: And we appreciate every one of you who listens, whether you chip in or not. Now back to the structural deficit — because there's one more layer I want to add. Luna: Go for it. Lucas: There's a concept called 'fiscal dominance,' which is when monetary policy becomes subservient to fiscal needs — the central bank can't raise rates enough because the government can't afford higher interest payments on its debt. That's a classic emerging market problem, but some economists worry it could creep into advanced economies if structural deficits stay high for too long. Luna: That would be a nightmare scenario — the central bank losing its independence de facto even if it's de jure independent. Lucas: Exactly. For now, no major central bank is there. But the structural deficit is the canary. When the cyclically adjusted balance stays deep red year after year, even in good times, it's worth asking who's going to blink first — the treasurer or the central banker. Luna: So next time you see a budget, look beyond the headline deficit number. Ask: is this structural or cyclical? The answer might tell you a lot about where interest rates are headed. Lucas: That's our show for today. We'll be back next episode with another angle on the tools central banks use. Until then, keep questioning the numbers.