February 1, 2024
As expected, Bank of Canada Governor Tiff Macklem held the line on interest rates on Wednesday.
In his statement, he added that bank’s concerns now shifted “from whether monetary policy is restrictive enough to how long to maintain the current restrictive stance.” Therefore, the question analysts are now considering is: When will the bank start reducing interest rates?
Until not too long ago, many economists and financiers believed the bank would start dropping interest rates in April. Now, they are reconsidering this forecast since year-over-year inflation rose to 3.4 per cent in December from 3.1 per cent the previous month.
And, although for a reason other than persistent inflation, now they are right believing that, at the earliest, the bank will start lowering interest rates in June. Undoubtedly, the December spike in headline inflation did not come as a surprise since it was entirely due to the month-base effect.
Indeed, year-over-year inflation increased despite the fact that average prices fell 0.3 per cent in December. In other words, year-over-year inflation rose to 3.4 per cent because prices dropped more in the base month — 0.6 per cent in December 2022 — than last December. And not only in December did average prices fall. In the last quarter of 2023, prices decreased at an annualized rate of 0.5 per cent. Hence, currently there is deflation — not inflation.
Price inflation should not be of great concern
Further, although CPI has increased since June, it has risen at an annualized rate of only 1.4 per cent over the last six months of 2023 — a rate lower than the bank’s two per cent inflation target.
Therefore, it appears that price-inflation should not be a topic of great concern at the present time. Consequently, the Bank of Canada cannot use stubborn year-over-year inflation as a reason to maintain interest rates at the current five per cent. Hence, if the bank decides to keep the policy rate unchanged in April, it must be for a different reason.
It appears that the main concern of the bank is not — and never was — price-inflation but rather wage-inflation. Indeed, bank officials have stated multiple times that annual wage increases in the four-to-five per cent range are not consistent with the two per cent inflation target — and, on a year-over-year basis, wages increased 5.4 per cent in December.
So, wages rose faster than prices in 2023, and thus they could be fueling inflation. “A wage-price spiral might be on the making,” we can hear inflation-hawks shouting. The evidence, however, suggests otherwise.
In December, for instance, average wages rose 0.5 per cent, while average prices fell 0.3 per cent. So, wages did not fuel inflation in December. Further, over the last three months, wages have been increasing at an annualized rate of 5.3 per cent, while prices have been falling — not rising — at an annualized rate of 0.5 per cent. So, wages did not fuel inflation in the last quarter of 2023 either.
And even more significantly, over the last six months, wages have been rising at an eye-popping annualized rate of 8.2 per cent compared to prices increasing at a moderate rate of only 1.4 per cent. So, definitely, wages are not fueling inflation.
Wages are slowly recovering purchasing power
What wages are doing is slowly recovering the purchasing power they lost during the supply-driven inflationary period since early 2021, but without causing a wage-price spiral. And this process still has a way to go since prices have risen 15.2 per cent in the last three years while wages have increased only 14.1 per cent — so today’s real wages are still lower than in December 2020. But if inflation is not a problem and wages are not fueling inflation, why does the Bank of Canada continue keeping interest rates so high?
One possible reason could be that it wants to prevent a depreciation of the loonie with its potential negative impact on inflation. Indeed, we don’t live in a vacuum, and thus any decision by the bank to lower interest rates has to be done in tandem with a similar decision by the U.S. Federal Reserve to preserve the value of the Canadian dollar.
Another possible reason could be that the bank is trying to prevent further wage increases to protect firms’ profit margins. If this is the intention, so far it has not succeeded even though unemployment has risen by almost one percentage point representing about 150,000 more Canadians out of work.
If this is the reason not to lower interest rates, then the Bank of Canada should answer the following question: how much must unemployment rise for wage-increases to fall in the two to three per cent range the bank considers consistent with the two per cent inflation target?
Hard to say. But, in any case, profit margins should not be increased at the cost of lower wages — it should be hiked through increases in productivity. Therefore, Canada doesn’t need higher interest rates to reduce labour demand nor greater immigration to increase labour supply.
What Canada needs is to increase its productivity — and high and rising real wages are the best incentive for firms to undertake productivity-enhancing investment.
And, undoubtedly, this would be the best possible outcome — a win-win situation for capital and labour.
