Don't expect Canadian interest rates to fall this year
Lower headline inflation hides deeper problems
Inflation is reportedly declining and Liberal leaders are taking credit. But the underlying forces driving inflation suggest it is not declining much and is more likely to rise than to fall.
What forces?
Wage prices are the key to inflation projections since higher wages compel higher inflation unless offset by higher productivity. But since Trudeau was elected in 2015, Canadian productivity virtually flatlined until a short upward burst in 2020 which quickly reversed itself. Express in 2012 constant dollars across all industries, productivity in Canada has fallen from $65 in 2020 to $61.1 in 2022 and I suspect has fallen further since that time.
Lower productivity would not be inflationary if wages dropped in tandem, but the opposite is happening. Since 2015, the average Canadian wage has risen from about $23 an hour to about $30 an hour, according to data from Trading Economics derived from Statistics Canada. While that rate of increase averages 3.8% over the period, it was almost 6% in 2023 and is expected to rise 3.6% in 2024.
Source: Trading Economics
If productivity were falling at 2% per year and wages were rising at 3.6%, unit labor costs would rise by 5.6% and that is a lot higher than the Bank of Canada’s target of 2% inflation. Since Trudeau came into office, unit labor costs in Canada have risen a cumulative 32.8% or an annual rate of about 4.5% continually compounded.
Canada’s headline inflation rate has abated somewhat owing largely to a decline in energy costs, while longer lead time costs that all households must pay (e.g. rent, mortgage, vehicle replacement, higher education for children) don’t respond immediately to changes in policy rates, but have effect when leases end, mortgages come up for renewal, a new car is needed or when children graduate from secondary schools and face the costs of higher education.
The stage is set for renewed increases in the rate of inflation. Labor agreements signed in that include both raises in base rates and cost of living adjustment (COLA) will outpace the 2% inflation goal set by the Bank of Canada. A high number of Canadian labor agreements have COLA clauses, particularly in the civil service.
A few high profile labor contracts come up for negotiation in 2024 including CBC, Canada Post, VIA Rail and many Provincial agencies. There is little doubt these will result in higher public sector wage growth in excess of target inflation rates. The size of the public service has grown dramatically under Trudeau and related wages have risen over 50% during his regime as reported by the Toronto Sun. Public sector wages and benefits are the targets for private sector unions and tend to force private sector wage costs upwards.
Increases to the useless carbon tax will result in higher costs of home heating, electricity and transportation. Faced with higher wage costs and lower productivity, businesses are forced to raise prices. It become a classical wage-price inflation scenario that typically only abates when unemployment rates rise materially but Canada’s unemployment rate is falling - dropping from over 9% during COVID to about 5% today.
Improvements in productivity typically arise from higher capital expenditure and greater investment in research and development. Capital expenditure in Canada at 24.53% of GDP in 2024 is only marginally higher than the 23.82% recorded in 2015. The Trudeau government has made Canada a hostile environment for corporate capital in my opinion. Not surprisingly, that hostile environment has seen Canadian investment in R&D (measured by Gross Expenditure on R&D as a percetage of GDP, or GERD) fall steadily and sit well below the OECD average. The result is a less-competitive Canadian industry, higher reliance on imports and upward pressure on prices.
In conclusion, it is far too early for the Bank of Canada to claim victory over inflation (and Tiff Macklem has avoided doing so) or for Canadians to expect lower Bank of Canada policy rates any time soon. In my opinion, higher rates are more likely as evidence mounts that inflation will be higher for longer.
Trudeau’s government has created an ugly mess for Canadians and it makes no sense to live in hope rather than face facts and take the first opportunity to toss the Liberals out of office.