Wage growth could prompt faster policy tightening

The Bank of Canada’s fourth-quarter Business Outlook Survey showed firms’ wage expectations at a record high, which suggests that wage growth could accelerate to far above the pre-pandemic norm this year. With little sign yet of a rebound in productivity growth, such a strong pace of wage growth would present a clear upside risk to our price inflation forecasts. Until now, most economists have assumed that the Bank will take a relatively slow approach to policy tightening, with the consensus forecast consistent with one interest rate hike per quarter, based on the logic that elevated household debt and stretched house prices mean the economy is more sensitive to interest rate hikes than in previous cycles. We doubt, however, that the Bank will be overly concerned about those risks during the early stages of its tightening cycle. If wage growth accelerates in the coming months, the Bank may therefore choose to raise interest rates more quickly to begin with, before taking a slower approach once the policy rate has reached perhaps 1.0% or so. Either way, given the risks of higher borrowing costs to the housing market, we remain doubtful that the Bank will hike by as much in the next couple of years as markets are now pricing in.