Demystifying the links between rate hikes, inflation and a tight labour market

After pausing increases to its overnight rate in January, the Bank of Canada announced another hike this Wednesday.

By adjusting the overnight rate, the bank aims to dampen aggregate demand (total demand for goods and services), free up the labour market, and nudge the economy back onto a path of predictable and stable price growth.

But the bank’s efforts have been hampered by the complex tangle of domestic and global factors that are driving this latest inflationary cycle. Influences include global supply chain disruptions, geopolitical uncertainty, rising domestic demand, and production costs.

The resulting sticky inflation is having real consequences for ordinary Canadians.

The impacts of almost two years of stubborn inflation can be seen in the increasing numbers of Canadians who are struggling to fill their grocery carts, watching their retirement nest eggs dwindle, or seeing their dreams of homeownership fade with each passing day.

One bit of good news is that the U.S. Federal Reserve’s Global Supply Chain Pressure Index (GSCPI), which measures supply chain disruptions, peaked in December 2021—coinciding with the early uptick in inflation—and has since returned to pre-pandemic levels. As foreign supply disruptions dissipate, the Bank of Canada will be able to use rate hikes more effectively to address domestic drivers of inflation, such as aggregate demand.

But it will be more difficult to deal with the influence of Canada’s tight labour market. Faced with tight labour markets and rising nominal wages, domestic businesses have responded by passing on their rising labour costs to consumers through higher prices.

Compounding the challenge for the Bank of Canada, government support programs designed to mitigate the impacts of significant pandemic employment losses helped sustain demand for goods even as many service-oriented businesses were forced to close. As lockdowns lifted, the pent-up demand for services outpaced businesses’ ability to rebuild their workforces, driving up the cost of labour.

Rising wages increase production costs for businesses and can increase consumer spending, contributing to a wage-price spiral: rising wages increase both consumption and production costs, which feed into inflation—and if wages continue to rise, inflation spirals higher and higher.

The Bank of Canada’s interest rate policy affects the labour market by increasing the cost of borrowing. Consumers become less inclined to take out loans, and may delay major purchases or investments, leading to a decrease in consumer spending and demand.

Higher borrowing costs also discourage business investment, expansion and entrepreneurship, in turn reducing business activity and contributing to slower job creation or even job losses, particularly in sectors that rely heavily on borrowing, such as construction, real estate and manufacturing.

One sign that the central bank’s strategy is working, although it remains tight overall, is that the Canadian labour market is starting to show some signs of loosening. The latest job vacancy data from Statistics Canada (from the first quarter of 2023) have shown three straight quarters of declines in each of these sectors.

And while inflation has eaten away at most of the real wage gains from rising nominal wages until recently, wage growth is decelerating, according to the Statistics Canada Labour Force Survey and Job Vacancy and Wages Survey.

Job vacancies peaked in May 2022, but have since declined to their lowest level since July 2021. After hovering near a record low for six months, the unemployment rate nudged up for two consecutive months, reaching 5.4 percent in June.

Recent employment data reveal slower growth in summer student employment compared to previous years, indicating reduced labour demand from businesses.

These trends appear to signal a gradual loosening of the labour market, given that the number of unemployed persons per vacancy is increasing.

While the impact of the Bank of Canada's interest rate policies is yet to be fully realized, the interconnectedness of inflation, interest rates and the labour market will continue to influence Canadians’ daily consumption and labour market decisions for a while longer.