Skip to main content

In moving into a holding pattern on interest rates Wednesday, the Bank of Canada was in a pretty upbeat mood.

Sure, Canadian economic growth was slower than the bank had expected when it last updated its forecasts in January, but hey, when you’re trying to cool inflation, that’s a good thing. Okay, growth in the United States, Europe and China (which make up more than half of the world economy) is looking surprisingly strong, but the global economic picture remains “broadly in line” with the January outlook.

Yes, inflation – the focal point of the bank’s rapid-fire rate hikes over the past year – is still well above the bank’s 2-per-cent target. But relax, it remains on course to retreat from the current 5.9 per cent to about 3 per cent in mid-2023. The bank is confident that weaker economic growth, a consequence of its high interest rates, will let more air out of the inflation balloon over the next couple of quarters.

If none of this stuff much worries the Bank of Canada as it sits back to let a year’s worth of rate hikes do their job, then what does?

Well, jobs. And, more to the point, the wages that go with those jobs.

“Employment growth has been surprisingly strong,” the bank said in Wednesday’s seven-paragraph statement announcing its rate decision.

“Wages continue to grow at 4 per cent to 5 per cent [year-over-year] while productivity has declined in recent quarters.”

The central bank didn’t elaborate on that wage-and-productivity observation. But if you’re familiar with the context, it didn’t have to. This is a big deal on the Bank of Canada’s inflation radar. And the blunt assessment, within an otherwise pretty optimistic rate decision statement, suggests it’s now filling up a lot of the screen.

This was something the central bank talked about in its Monetary Policy Report in January. The bank was encouraged at the time that wage growth had “plateaued” at between 4 per cent and 5 per cent – and it had stopped rising. Still, it warned, “Unless a surprisingly strong pickup in productivity growth occurs, sustained 4-per-cent to 5-per-cent wage growth is not consistent with achieving the 2-per-cent inflation target.”

Now, six weeks later, it’s pointing to those wage inflation and productivity readings in a very public way – and neither is going in the right direction.

Wages can sustain a faster pace of growth, without fuelling broader inflation, if they reflect increases in labour productivity – that is, workers are producing more goods and services per hour worked. But what’s been happening instead over the past several quarters is that labour employed in the economy has been growing faster than output.

Last week, Statistics Canada reported that for 2022 as a whole, labour productivity – as measured by real gross domestic product per hour worked – fell 1.5 per cent, as real business GDP rose 3.6 per cent but total hours of employment jumped 5.2 per cent. In the fourth quarter, the pace of growth in hours worked slowed, but total business output actually declined; as a result, labour productivity fell for the third consecutive quarter.

It appears that amid an extremely tight Canadian labour market, businesses have been stockpiling labour even when they don’t have the productive capacity to fully use it. The competition for workers, together with more aggressive wage demands in light of the high inflation of the past couple of years, has pushed up the costs of labour – but businesses aren’t selling sufficient additional goods and services to pay for it. If they are to recoup those costs, the only option is to pass them along to customers.

It doesn’t take a PhD in economics to see how those unproductive labour costs represent a serious inflationary pressure. Unless the wage growth slows or the productivity accelerates, the Bank of Canada has a problem toning inflation down to its desired 2 per cent.

The bank is hoping that as its high interest rates dig in deeper and demand slows further, businesses will lose their appetite for hiring workers that they don’t really need. And, in turn, that slower labour demand will ease the competition for workers that has contributed to wage growth.

It would also help if productivity would pick up. But with business investment slowing in response to a slow and perhaps even recessionary year ahead, the prospects aren’t great for technology gains to boost per-worker output in the relatively short term.

So, the Bank of Canada is faced with, essentially, rooting for a slowdown in wage growth. And the longer this wage-and-productivity dynamic remains unhelpfully sticky, the more central it will become to the central bank’s public message on its inflation fight.

That won’t be a popular message for the bank to deliver to Canadians whose real incomes have been eroded by high inflation. But it’s critical to understanding where interest rates will go from here. Wage growth isn’t just the biggest obstacle on the path to eventual rate cuts. It now looks to be the biggest reason why further rate hikes are still on the table.