Focus shifts to labour market in inflation fight

With inflationary pressure from supply chains and energy prices easing, central banks will be more focused this year on domestic labour markets and avoiding the dreaded wage-price spiral that could keep inflation higher for longer.

“There’s no question: the labour market is in excess demand,” said Warren Lovely, managing director and chief rates and public sector strategist with National Bank Financial, speaking Tuesday at a webinar hosted by the Global Risk Institute (GRI).

The Canadian economy added 104,000 jobs in December, surprising economists and raising expectations for higher interest rates to cool the labour market. The unemployment rate fell to 5.0% last month.

With labour so scarce and in demand, there’s risk of a wage-price spiral, Lovely said, with workers negotiating higher pay to offset higher prices and resulting in inflation staying elevated for longer.

“As long as labour markets remain this tight,” he said, “the victory on inflation may be harder to come by.”

In a report released Tuesday, RBC senior economist Josh Nye said the latest jobs data could push the Bank of Canada toward another quarter-point hike on Jan. 25.

While the jobs data are a lagging indicator, Nye wrote, with the impact of interest rate hikes still working through the economy, “for a central bank emphasizing data dependence, it will be hard to pass up another hike.”

“If central banks continue to hike until there is clear evidence that unemployment is trending higher, they risk overtightening,” the RBC report said.

“At some point policy-makers will have to judge whether monetary policy is restrictive enough to return unemployment and wage growth to more sustainable levels over time. The BoC looks closer to doing that than other central banks, but perhaps not as soon as January.”

McGill University economics professor Christopher Ragan, speaking at the GRI webinar with Lovely, said it’s “very unlikely” that the Bank of Canada has gone too far already and overtightened.

He pointed to inflation expectations from businesses for the next two years remaining above the central bank’s target range.

The Bank of Canada’s next Business Outlook Survey, to be released Jan. 16, will provide an important update on how the bank is doing in managing inflation expectations, he said.

Ragan noted the challenges central banks face as we emerge from the Covid-19 and its “tremendous supply shock.”

“There’s tremendous uncertainty, and we should have tremendous humility about our estimates of potential output and the output gap,” he said.

“We’re just now coming out of that very bizarre world. I think it will be a while before we can have as much faith as we did before in our estimates.”

But Ragan said he doesn’t believe that higher inflation is inevitable. It just may take longer and require more rate increases than it previously did to get prices back under control.

“I’m still one of those older, uncreative people who believe that sustained inflation is ultimately coming from monetary policy, and that if central banks choose to want to return to a 2% inflation target, they can do it and they know how to do it,” he said.

Nye said RBC expects the BoC to hold after a 25-basis-point hike this month, with 4.50% as the terminal rate.