As inflation soars and wages stay stagnant, Bank of Canada survey signals pressure to move aggressively on rate hikes

Bank of Canada Governor Tiff Macklem takes part in a news conference in Ottawa on March 3.BLAIR GABLE/Reuters

Canadians are increasingly worried that consumer prices will keep shooting up while wages stagnate, a sign that inflation expectations are becoming unmoored from the Bank of Canada’s target, which may force it to move aggressively to raise interest rates.

According to the central bank’s latest survey of consumer expectations, published on Monday, consumers think the rate of inflation will be about 5 per cent next year and about 4.6 per cent in two years. By contrast, survey respondents thought their wages would grow by only about 2 per cent.

“This is a source of dissatisfaction for them,” the central bank noted. The survey was conducted in the second half of February, with follow-up consultations in March.

On inflation, the government and the Bank of Canada are pulling in opposite directions

A separate survey of businesses found that companies also expect inflation to remain high over the next few years, with many reporting increased labor and input costs and saying they expect to pass these extra expenses on to customers.

The pair of surveys adds to the argument that the Bank of Canada may need to make an oversized interest rate hike at its upcoming rate decision on April 13. Canada’s top central bankers have hinted in speeches over the past month that an increase of 0.5 percentage points is on the table. Usually, the bank moves in increments of 0.25 percentage points.

The bank raised its policy interest rate to 0.5 per cent from 0.25 per cent in early March – the first hike since 2018, and the first move in what economists expect will be a rapid monetary policy tightening cycle.

“If we still needed to cement the case for a half-point rate hike in April, the Bank of Canada’s Business Outlook survey provided it, at least in terms of inflation expectations,” Canadian Imperial Bank of Commerce chief economist Avery Shenfeld wrote in a note to customers.

“The bank will take note that a strong majority see inflation over 3 per cent for the next two years, and that’s something that the bank wants to lean against,” he said.

Central bankers pay close attention to people’s expectations about inflation, because where consumers and businesses believe inflation will go has a direct bearing on where prices end up. With inflation hitting a three-decade high of 5.7 per cent in February, the worry is that today’s inflation will become entrenched in expectations for future inflation, making the Bank of Canada’s job much harder.

“The lesson from history is that if inflation expectations become unmoored, it becomes much more costly to get inflation back to target,” Bank of Canada Governor Tiff Macklem said in early March, which would mean the bank would have to raise interest rates higher and faster. Interest rate increases theoretically bring down both inflation and people’s expectations for future inflation.

While expectations of short- and medium-term inflation have risen sharply, longer-term expectations remain relatively well anchored to the central bank’s 2-per-cent target, the surveys found. Consumers expect inflation to be around 3 per cent in five years, which is below the survey’s historical average. Fewer than 10 per cent of business survey respondents thought inflation would be substantially above 2 per cent in three to four years.

Royce Mendes, head of macro strategy at Desjardins, cautioned against taking too much solace in these longer-term survey findings.

“Reading between the lines, it seems like inflation expectations are gradually becoming unmoored. Even though respondents see inflationary pressures fading as the pandemic and supply chain disruptions subsidize, the Bank of Canada needs to be on high alert to keep longer-term expectations anchored,” Mr. Mendes wrote in a note to clients.

“In an attempt to ward off a further move in inflation expectations, it’s time for the Bank of Canada to unleash some ‘shock and awe,’” he added.

“A faster pace of rate hikes won’t do very much to change inflation’s destination a couple of years from now. That will be determined by the ultimate level of rates. Still, it’s clear that the Bank of Canada needs to take drastic action to show Canadians that the 2-per-cent inflation target is still sacrosanct.”

Alongside taking stock of inflation expectations, the business survey found that companies are seeing strong demand for their products, but many have labor shortages and supply chain problems. A record-high four out of five businesses said they would have some or significant difficulty meeting an unexpected increase in demand.

The survey was conducted before Russia invaded Ukraine, which has further disrupted supply chains and pushed up commodity prices. In a follow-up survey conducted online in early March, around half of the respondents said they anticipate the conflict will affect their businesses, largely through higher energy prices and further supply chain problems.

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