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Canadian businesses and consumers expect to feel the pinch of inflation for an extended period of time as continuing supply chain disruptions and labour shortages push up costs and strong demand allows companies to pass these increases along to customers.

A Bank of Canada survey of businesses conducted in November and early December found two-thirds of respondents expect inflation to remain above 3 per cent over the next two years. A separate survey of consumers found that people expect the rate of inflation to be nearly 5 per cent a year from now, and still more than 4 per cent two years from now.

“Compared with before the pandemic, inflation has become the most important economic variable to Canadians, ahead of jobs and taxes,” the Bank of Canada said.

These findings will be concerning for the central bank and will increase pressure on bank governor Tiff Macklem to start raising interest rates in the coming months, perhaps as early as the coming rate decision on Jan. 26.

New wave of COVID-19 forces Bank of Canada to reassess interest rate decision

Inflation expectations have a sizable impact on where inflation ends up, as companies set prices and employees demand wages based on what they think the rate of inflation will be over the coming years. A large part of monetary policy is trying to keep inflation expectations anchored around the central bank’s 2-per-cent target to prevent wage-price spirals.

This is becoming more difficult as inflation has remained above target since April of last year, and worries about the rising cost of living have become a major political issue and everyday point of conversation. The annual rate of inflation hit 4.7 per cent in October and November. The December consumer price index numbers will be published Wednesday.

Fifty-seven per cent of respondents to the consumer survey said they were more concerned about inflation than before the pandemic, and 65 per cent of respondents believed that it is now more difficult to control inflation.

The survey of around 2,000 consumers was conducted in mid-November, while the survey of around 100 businesses was conducted from mid-November to early December. The findings reflect business and consumer sentiment before the Omicron wave and the latest round of lockdown measures.

Inflation expectations are rising against the backdrop of tight labour markets and gummed-up supply chains. Businesses reported significant capacity pressures, with 78 per cent of firms saying they would have some difficulty or serious difficulty meeting an unexpected increase in demand.

Labour shortages are a particular problem, with four in 10 companies saying that an inability to find workers is holding back their sales. That’s feeding into plans to increase wages to compete for scarce labour. Around 80 per cent of companies said they intend to raise wages at a faster pace over the next year than over the previous year.

“Reports of wage competition among firms have picked up and are present in most regions and sectors. They are particularly prominent in highly skilled occupations and in the technology sector,” the Bank of Canada said.

“The cost of living is increasingly contributing to wage pressures as well. Some firms noted that they now plan to catch up on wage increases after having a limited ability to raise wages earlier in the pandemic,” the bank added.

Companies are preparing to pass rising input costs along to customers. This will be aided by strong demand for many goods.

The business survey found that indicators of future sales remain elevated for companies in sectors that have done well during the pandemic, such as housing, retail and manufacturing, although it noted that future sales in these sectors are increasingly held back by supply-side constraints.

Benjamin Reitzes, the Bank of Montreal’s managing director of Canadian rates, said the survey results increase the probability that the Bank of Canada will start raising interest rates at its meeting next week. Financial markets are pricing in around five interest-rate increases this year.

“Simply put, higher inflation is driving higher wages, which is driving price hikes, and then we’re back to inflation. The Bank of Canada cannot be comfortable seeing this feedback loop building,” Mr. Reitzes wrote in a note to clients.

“While sentiment has likely been dampened by the surge in [COVID-19] cases, the starting point for the economy is much stronger than expected. Rising capacity pressures and inflation expectations suggest that a rate hike at next week’s policy announcement is now a very real possibility,” he said.

Despite the rise in short- and medium-term inflation expectations, longer-term expectations for consumer price growth appear to be relatively well anchored. The median prediction for inflation five years out was 3.5 per cent in the consumer survey, which is below the historical average. The bank also said that most firms reported expecting inflationary pressures to dissipate over time, and inflation to return close to target in one to three years.

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