The Canadian economy continues to perform better than expected, with Statistics Canada reporting an outsized employment gain for September. Propelled by a similar result in the U.S., bond yields reached their highest levels in over a decade as markets clearly expect both inflation and interest rates to remain higher for longer.

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Philip Cross: Higher inflation risks becoming entrenched in Canada Back to video

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As measured by the consumer price index, Canadian inflation has accelerated from its recent low of 2.8 per cent in June back up to 3.8 per cent in September. The upturn was widely expected because of “base-year effects”: the drop in gasoline prices last summer is being replaced in the index by this summer’s higher prices.

But what’s pushing driving inflation is more than energy prices. Measures of “core” inflation that don’t include energy prices remained stubbornly near four per cent even as lower gasoline prices pulled down headline inflation. The cost of services rose 3.9 per cent in September, led by a surge for renters as Canada’s housing shortage worsened. Meanwhile, wage increases accelerated to 5.0 per cent in the latest jobs report.

It was predictable that the deceleration of inflation during the first half of 2023 would not last. Most of the easing of the headline number was due to improvements in supply, notably in the energy sector after Russia’s invasion of Ukraine had sent prices soaring. Aggregate demand has barely slowed, outside of new home construction, suggesting interest rates still are not high enough to curb inflation. This is especially true when governments continue to run deficits. In the U.S., this year’s deficit — equal to six per cent of GDP — is straining an economy already operating at full employment. Meanwhile, households still have substantial savings balances, in part because of excessively generous government transfers during the pandemic. As a result, after an initial downturn in the spring in response to higher interest rates, house sales began to heat up again after the Bank of Canada prematurely indicated it would pause further interest rate hikes.

The ongoing imbalance between aggregate demand and supply is reflected in historically low unemployment — just 5.5 per cent in September — which puts more upward pressure on wages. At first, higher wages were driven by labour shortages, especially in industries with below-average wage rates, such as restaurants and retailing. The challenge was to limit this initial round of wage increases to these low-wage industries where it was hard to find staff after the pandemic. But wage hikes have become more widespread as most workers try to recoup purchasing power lost to higher prices, including via several high-profile strikes across North America.

Though faster wage increases are an understandable reaction to higher inflation, they risk making a return to low inflation more difficult. Federal Reserve Board Chair Jerome Powell recently said wage increases of three to 3.5 per cent were consistent with the Fed’s two per cent inflation target, since higher productivity allows wages to rise more than prices without fueling inflation. To be non-inflationary in Canada, however, wage increases need to be lower because of our falling labour productivity, which has tanked in eight of the last nine quarters, registering a cumulative decline over that period of nearly six per cent.

The Bank of Canada recently acknowledged that inflation is in danger of becoming entrenched at greater than two per cent per year as workers become more militant about recouping the purchasing power they have lost to higher prices. It noted that firms are changing their pricing behaviour in response to rising costs and are adjusting their prices more than the once or twice a year that was customary when inflation was quiescent.

It makes perfect sense that both workers and firms should change their behaviour in an environment of steadily rising prices, but their doing so risks triggering a wage-price spiral that complicates returning to the two per cent inflation target. John Cochrane of the Hoover Institution offers a good description of a wage-price spiral in his new book The Fiscal Theory of the Price Level: “If you ask the grocer why the price of bread is higher, the grocer will blame the wholesaler. The wholesaler will blame the baker, who will blame the wheat seller, who will blame the farmer, who will blame the seed supplier and workers’ demands for higher wages, and the workers will blame the grocer for the price of food.”

The best solution would have been to contain inflation before it took off in 2021, but persistent government deficits and the Bank of Canada’s lethargic response to higher prices squandered that opportunity.

Philip Cross is a senior fellow at the Macdonald-Laurier Institute.