BoC deputy governor highlights labour market uncertainty, complicating rate hike timing

The Bank of Canada is grappling with labour market uncertainty as it tries to gauge the health of Canada’s economic recovery and estimate a timeline for interest rate hikes in the face of surging inflation, deputy governor Lawrence Schembri said Tuesday.

Mr. Schembri used a speech to the Canadian Association for Business Economics to highlight the central bank’s commitment to achieving full employment before raising interest rates.

At the same time, he said that shifts in demographics, technology and the nature of work during the pandemic have made it harder for central bankers to determine the maximum sustainable level of employment in the Canadian economy. Likewise the relationship between labour market tightness and inflation has weakened in recent years.

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“Our assessment of labour market conditions and underlying capacity and inflationary pressures is now more difficult. Consequently, more uncertainty exists around the timing of when the output gap will close and inflation will return sustainably to our 2-per-cent target,” he said.

Uncertainty around the labour market has major implications for interest rates. The central bank has promised not to raise its policy interest rate – held at 0.25 per cent since early in the pandemic – until the economy is operating at its full potential. From the perspective of the labour market, this means keeping rates at rock bottom until a broad range of workers have returned to the labour force and found employment.

The Canadian labour market has experienced a major rebound in recent months, with the level of employment returning to prepandemic levels in September. But there are still areas of weakness, including a high share of long-term unemployed workers, elevated unemployment for older workers and slow wage growth.

“We’ll keep the policy rate at the effective lower bound [of 0.25 per cent] until excess capacity is absorbed … [and] that excess capacity includes all the groups of employees that aren’t fully employed at this juncture,” Mr. Schembri said in response to a question after the speech.

“Now of course, one has to take into account that there’s going to be some natural friction in the labour market, people are going to move between jobs, so we’re not saying that there has to be zero unemployment,” he added.

The Bank of Canada, like most advanced-economy central banks, is coming under increasing pressure to raise interest rates to rein in inflation. The annual rate of inflation has been above the bank’s 1-per-cent to 3-per-cent range since the spring, hitting 4.4 per cent in September. The consumer price index numbers for October, which will be published on Wednesday, are widely expected to show even higher inflation.

Canadian central bankers have repeatedly argued that the current period of high inflation is largely the result of supply chain congestion and high energy prices, which will dissipate over time. Nonetheless, the Bank of Canada moved to tighten monetary policy at its rate decision last month. It ended its quantitative easing program and shifted forward its timeline for a potential rate hike by a quarter, indicating that rates could rise in the middle of next year, perhaps as early as April.

What happens next depends largely on the bank’s view of the labour market, Canadian Imperial Bank of Commerce senior economist Royce Mendes wrote in a note to clients.

“The uncertainty surrounding the labour market’s health will be compounded by the fact that the economy could be facing a challenging winter with regards to the COVID-19 infections, suggesting a wait-and-see approach for the next few months,” Mr. Mendes wrote.

Mr. Schembri said the bank is looking at a broader range of labour market indicators than usual to assess how various demographic groups are faring and how close Canada is to achieving maximum employment.

Mr. Schembri’s focus on full employment echoes speeches made by Bank of Canada Governor Tiff Macklem over the past year. The bank’s increased emphasis on labour market inclusion has raised questions about whether it may be preparing to adjust its inflation targeting regime.

The bank is in the final stages of renegotiating its inflation targeting mandate with the federal government – a process that happens every five years, and which is expected to wrap up before the end of the year. One of the leading options under consideration is a “dual mandate,” which would see the central bank explicitly target full employment alongside 2-per-cent inflation, similar to the system used by the U.S. Federal Reserve.

CIBC chief economist Avery Shenfeld wrote in a note to clients last week that he expects the Bank of Canada to retain its existing “flexible inflation targeting” regime, while making some notable tweaks.

“We expect that more specific language will be added to enforce the idea that achieving sustained 2 per cent inflation will coincide with the attainment of full employment. That’s not quite a ‘dual mandate,’ but a half-step closer,” he wrote.

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