As inflation cools, higher wages could stand in the way of reaching 2% goal

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Weekly grocery bill has increased by over $100 say 1 in 5 Canadians: poll
WATCH: Weekly grocery bill has increased by over $100 say 1 in 5 Canadians: poll – Apr 30, 2023

Canadians’ wages are finally growing faster than prices as inflation continues to ease, but that isn’t necessarily good news for economists who worry high wage growth might stand in the way of bringing inflation back down to the two per cent target.

Statistics Canada’s consumer price index report set to be released Tuesday is expected to show inflation slowed once again in April.

A combination of easing global pressures and higher interest rates have brought inflation down significantly since last summer in both Canada and the U.S. Here in Canada, the inflation rate has been nearly halved, slowing from a peak of 8.1 per cent to 4.3 per cent in March.

TD is forecasting the annual inflation rate was 4.0 per cent in April. The commercial bank also expects food inflation, which has strained people’s finances considerably, eased last month.

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The slowdown in inflation gave the Bank of Canada justification to pause its aggressive rate hiking cycle earlier this year and opt for a wait-and-see approach.

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Your Money: Understanding the financial headlines

The Bank of Canada is forecasting inflation will fall to about three per cent in the coming months. The path to two per cent inflation is expected to be much longer, however, as the central bank expects inflation to return to target by the end of 2024.

Its key interest rate sits at 4.5 per cent _ the highest it’s been since 2007. Higher borrowing costs caused by the rate hikes are expected to nearly halt economic growth this year.

But the Bank of Canada has said it won’t be satisfied until inflation comes back to its two per cent target. To gauge what the path to two per cent inflation will look like, the central bank is keeping a close eye on a specific part of the economy: the labour market.

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The performance of the Canadian labour market has been somewhat of a mystery to economists. Forecasters have been surprised time and again by stronger-than-expected job gains, while the unemployment rate holds steady at five per cent.

The strength in the labour market is partly explained by strong population growth in the country that’s adding to the number of workers available to firms. Meanwhile, vacancies have eased from last summer as firms report fewer labour shortages.

But with an unemployment rate just above the country’s record low of 4.9 per cent, economists says the labour market is clearly still very tight.

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That tight labour market, the central bank argues, is a sign of an overheated economy that’s fuelling inflation.

A key element of the central bank’s worries is how the tight labour market is affecting wages. After lagging inflation for much of the run-up in prices, wage growth has now surpassed inflation, rising 5.2 per cent in April from a year ago.

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For workers who have been squeezed by the rising cost of living, this wage growth spells good news.

TD’s director of economics, James Orlando, says wages are now playing catch-up as workers seek compensation for inflation.

“After a long period of time of workers getting real pay cuts, because their wages have not kept up with inflation, you’re having offsetting effects where now this wage growth is, is starting to cause real wage gains,” said James Orlando, TD’s director of economics.

Recently, thousands of federal workers who walked off the job secured tentative agreements with the federal government that include significant wage increases meant to compensate for inflation. These workers, represented by the Public Service Alliance of Canada, will receive a 12.6 per cent compounded raise over four years in addition to a $2,500 lump-sum payment.

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Bank of Canada keeps key interest rate on hold again: Tiff Macklem

Orlando says unionized workers usually see their wages adjust after private sector workers, which means wages may continue to rise rapidly as more collective agreements are negotiated.

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BMO’s chief economist, Douglas Porter, says wage growth above inflation is normally not a problem if the economy is also experiencing productivity growth. But productivity growth has not been keeping up with wages, and in fact, has been on the decline recently.

“Unfortunately, Canada hasn’t had much productivity growth in recent years. So, it is a bit of a challenge for the inflation outlook,” Porter said.

Economists say higher wages are feeding into higher prices for services, which continue to rise rapidly even as goods prices have moderated. Wage growth won’t lead to higher inflation, Porter said, but it could make it harder to bring inflation down.

The Bank of Canada’s nervousness about the labour market and sticky inflation led its governing council to consider raising rates last month. It ultimately decided to remain on pause, but Governor Tiff Macklem sent a message to financial markets that they shouldn’t expect rate cuts anytime soon.

Rate hikes, Macklem has said, are far more likely.

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