Opinion: Despite falling inflation, wage growth leaves the Bank of Canada with a dilemma

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Charles St-Arnaud is chief economist at Alberta Central.

Recent rising wage growth in the country will be of concern for the Bank of Canada. After moderating to 3.9 per cent in June, hourly wage growth for permanent workers, one of the central bank’s preferred wage measures, has now risen to more than 5 per cent. This suggests that wages have increased by approximately 10 per cent (annualized) in the past three months, raising the probability that the bank could hike its policy rate again before the end of the year.

Considering recent inflation data, where interest rates are and the delayed impact of previous hikes, we believe that the central bank should be patient. Economists widely expect the Bank of Canada to hold the line on interest rates this week.

But with the way wages are rising, it is becoming gradually more tempting for the bank to hike rates, if not on Wednesday then at the next rate announcement in December.

Higher wages are inflationary through two channels: One affects the demand side of the economy, and the other, the supply side. In the first instance, higher wages improve households’ purchasing power, supporting an increase in demand, which exacerbates inflationary pressures. This is the “traditional” view of the impact of wages on inflation and the angle used by many commentators arguing that the central bank is waging a fight against workers when it urges wage restraint.

In our view, such wage gains to compensate for the loss in purchasing power are unlikely to be keeping the bank up at night. While collectively, consumer expenditures have increased this year thanks to population growth, spending per capita is lower, suggesting households are not using income gains to increase their spending.

The second channel – which is how higher wages lead to an inflationary supply shock – is likely the main source of worry for the central bank.

Rapid wage growth, not supported by productivity gains and/or adjustments for the cost of living, leads to increased costs for businesses. The higher input cost will likely be passed on to consumers through higher prices, with business surveys showing that rising wages are a significant concern for most companies. Bank of Canada deputy governor Nicolas Vincent’s recent speech showed that, in the current higher inflationary environment, pricing behaviour has changed in recent years, with firms increasing prices more frequently than before.

The transfer of higher input costs to consumers, which contributes to higher inflation, prompts consumers to demand compensation for the higher cost of living; this, in turn, increases business costs, perpetuating an inflationary cycle. This inflationary loop is what the Bank of Canada is hoping to avoid by trying to contain wage growth, especially since persistently high inflation will lead to a rise in inflation expectations, making it more difficult to bring inflation back to target.

There are two ways to prevent this inflationary loop: 1) Workers show restraint in recovering the losses in purchasing power by agreeing with their employers to spread wage increases over an extended period – smaller pay rises but for longer. However, such an agreement could come at the expense of decreased labour-market flexibility; 2) The central bank increases rates to slow the economy, leading to an underperformance and some slack in the labour market, holding back wage gains.

At the current juncture, if wage growth does not ease, the bank may feel it has no other choice than to increase its policy rate. This would be especially true if underlying inflationary pressures remain stubbornly elevated with little signs of easing.

However, the risk of overtightening is real. With monetary policy in restrictive territory, after a 475-basis-point increase in the policy rate, with its full impact likely to only be felt in 2024, and rising insolvencies, an increasing number of households are struggling financially. The risk to the economy is significant job losses from a weakened labour market. Given high household indebtedness, the resulting impact on household income and their capacity to service this debt could lead to a hard landing for the Canadian economy and a deep recession.

As a result, continued wage growth and persistent inflation leave the central bank with a significant dilemma. Should it prioritize returning inflation to its target, its official mandate, at the cost of rising hard-landing probability and financial stability risks, or should it be more cautious in its approach, at the risk of persistently elevated inflation, requiring a more robust intervention later?