Unraveling the Bond Between Rate Hikes, Inflation, and a Tight Labour Market

After pausing increases to its overnight rate last January, the Bank of Canada is expected to announce a second consecutive hike this Wednesday.By adjusting the overnight rate, the Bank of Canada aims to dampen aggregate demand -- total demand for goods and services -- loosen the labour market and nudge the economy back onto a path of predictable and stable price growth.But the Bank's efforts are hampered by the complex tangle of domestic and global factors that are driving this latest inflationary cycle: global supply chain disruptions, geopolitical uncertainty, rising domestic demand and production costs.And this has real consequences for ordinary Canadians.Almost two years of stubborn inflation has meant more Canadians struggling to fill their grocery cart, watching the value of their retirement nest egg dwindle, or the dream of homeownership seeming less likely 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 now be able to more effectively use rate hikes to address domestic drivers of inflation such as aggregate demand.More difficult for it will be dealing with Canada's tight labour market.  Facing tight labour markets and rising nominal wages, domestic businesses have passed 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 maintain the demand for goods even as many services businesses were forced to close.As lockdowns lifted, the pent-up demand for services outpaced businesses' ability to rebuild their work force and drive up the cost of labour.Rising wages increases production costs for business and can increase consumer spending contributing to a wage-price spiral: rising wages increases 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 affect the labour market by increasing the cost of borrowing.Consumers become less inclined to take out loans and they may delay major purchases or investments, leading to a decrease in consumer spending and demand.Business investment, expansion and entrepreneurship are also discouraged by higher borrowing costs, reducing business activity, and contributing to slower job creation or even job losses, particularly in sectors that heavily rely on borrowing such as construction, real estate, and manufacturing.A sign that the central bank's strategy is working, although it remains tight overall, the Canadian labour market is exhibiting some signs of loosening.The latest Job Vacancy data from Statistics Canada (2023 Q1) has 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 Labour Force Survey and Job Vacancy and Wages Survey at Statistics Canada.Job vacancies peaked in May 2022 but have since declined to the 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 reveals 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, as 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 the daily consumption and labour market decisions of Canadians for a while longer.Brittany Feor is a Senior Economist at the Labour Market Information Council (LMIC).Michael Willcox is an Economist at the Labour Market Information Council (LMIC)