#inflation #wages #monetarypolicy = The Bank of Canada has had a razor-sharp focus on constraining wages, driven up by tight labour market and skills shortages, in the belief that these will feed into consumer prices. These will feed back through prices creating the dreaded wage spiral. This note will explain why the structure of the Canadian economy makes this wage-centric view less relevant.
Domestic wages are not the main driver for consumer price inflation.
Since the 1970s, the intensity of imports, as measured relative to population, has risen by more than a factor of 5. The scale of imports in consumer expenditure makes domestic wages less relevant to price formation.
Only slightly more than 16 per cent of the value of consumer durables (cars, furniture etc.) was produced in Canada in 2021. Many individual categories have much higher import shares. For example, we import most of the cars we buy. We also import most of the major appliances for our homes.
For semi-durables, the aggregate including clothing, the average domestic production share was only 5.3 per cent. Indirect taxes are much more important to domestic prices than domestic production. The domestic production share of garments is only 3.3 per cent.
The main point is clear. Foreign labour costs are a bigger component of Canadian inflation than Canadian wages. This makes discussions of a wage price spiral rather unrealistic. Canadian wages do not feed back onto prices. Canada’s demand is tiny relative to world supply although logistics issues may impose some short-run import challenges.
The prices of non-durable consumption items such as food and energy have been driven up by prices tied to external factors such as weather and war-driven world supply and market failures for inputs such as fertilizer, natural gas, and crude petroleum.
Canadian food and energy consumption responds much less than proportionately to price increases. That is why the grocery and gasoline retailers have been able to expand their margins with impunity. This reflects the inadequate domestic competition in these distribution sectors. While not creating the underlying supply-based price shocks, the merchants have profited from them. Wage studies show that workers in these sectors have not benefited from these expanded margins. Grocers can fatten their margins because they can get away with it. The grocery sector has lost market share and volume to the general merchandisers but still has increasing profits.
Competitive sectors such as women’s clothing show a contrasting picture. Notwithstanding an almost total dominance of foreign supply, margins and prices have been falling in that sector as supply chain factors eased.
Transportation costs are included in goods prices and are not part of the CPI services aggregate. If we want the food or energy, the goods must move.
Other service costs might be considered an issue. For example, financial service prices have recently been contributing significantly to the inflation picture. However, it is questionable if they will respond much to tighter monetary policy because there is almost no apparent relation between the increases and the wage growth in the sector. Mortgage interest is a separate issue.
The services component of the CPI is dominated by shelter costs. That is why the Bank of Canada reports an inflation measure in its Monetary Policy Report that excludes shelter costs. Shelter costs are generally considered to driven by competition for an inadequate supply. Matching demand to supply in this sector would likely require an intolerable increase in interest rates with significant collateral damage in the rest of the economy. There is also a critical feedback loop between affordability and rent. Rental competition increases as mortgage rates rise. This is exacerbated by landlords leaving the market because they can’t afford the mortgages.
Mortgage interest costs are a CPI element which is directly linked to Bank of Canada Policy. There is some discussion that decreasing competition in the banking sector may increase the markup from the Bank rate.
As a CPI services category, the interest costs are larger than restaurant costs (which include the ingredient and operating costs). Wages are less significant than might be assumed.
Property taxes have a larger share than categories such as financial services (fees - separate from mortgage costs), vehicle, or property insurance. There is no direct connection between domestic wages and these categories. Monetary tightness is not of value in constraining price growth in any of these sectors.
Higher interest rates have the effect of raising the income of asset holders (usually the more affluent) and causing severe stress and unemployment to others. This can have disastrous long-term consequences for our society.
Monetary restraint, with its broad economy wide impact, may not be the appropriate tool for managing the detailed category issues outlined in this note. Domestic wages are not the problem. Issues of market failure and supply factors should be addressed with other tools.
My country neighbour used to say that if you did not have the right tool for the job, don't try to do it. It is just not clear that excessive monetary tightness will provide benefits to the domestic economy that exceed costs.
We have got to a policy rate which will have long-term implications for the economy. Patience is a virtue. We should leave well-enough alone and not consider further increases so that Canadians can securely plan.
It's a good note and I agree with much of it. However, it would benefit from some discussion of inflation expectations, not just on the part of workers seeking to have their wages 'keep up', but also on the part of consumers, businesses and investors. I think the BoC's interest rate increases are as much to signal the Bank's intolerance of rising expectations as anything else. There is also the point that prior to the interest rate increases real rates were negative. If inflation were successfully held in the target range, even then rates should be somewhere above that. Negative real rates were an appropriate policy at the height of the crisis, when the economy stumbled, but they should not be sustained when the economy is getting back on track. Finally, I think the Bank is more concerned about wage inflation in the services sector that you seem to believe. I am thinking about personal services, recreation, entertainment, education, health, transportation via ports, rail, trucking and so on. These sectors are labour intensive and the possibility of 'wage spiral' forces developing via these industries is a lot more real than in the goods sectors you refer to where, indeed, prices are determined abroad to a great extent (assuming no compensating exchange rate changes).