Soaring inflation expectations raise odds of super-sized Bank of Canada hike

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The Bank of Canada’s latest quarterly surveys of business and consumer expectations show growing doubt about the central bank’s ability to put a lid on inflation, increasing the odds of a bigger-than-usual interest-rate increase later this month. Here’s what you need to know:

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Businesses

The Bank of Canada’s first-quarter survey of businesses was conducted before Russia invaded Ukraine, so it wasn’t a useful guide of what company leaders think about the world in which we live now.

Participants answered lots of questions, but the only ones that really matter right now are those related to inflation, which surged to 7.7 per cent in May, as measured by year-over-year increases in Statistics Canada’s consumer price index. The results were concerning. Elevated numbers of companies continue to struggle with supply bottlenecks and labour shortages, suggesting the “presence of excess demand in the economy,” which is inherently inflationary.

Nearly half of companies said they expect wage increases will remain above pre-pandemic levels for the next 12 months, in part because workers are insisting on being compensated for a higher cost of living. Most businesses said they expect inflation will remain “substantially” above two per cent for at least a couple of years, and a quarter of respondents said they saw inflation staying that high for longer.

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The survey has a relatively small sample size: the Bank of Canada’s regional offices conduct 100 interviews per quarter from a rotating roster of businesses. However, policymakers trust the results, and the report ranks as one of the most important inputs into interest-rate decisions.

Consumers

Short-term expectations of inflation climbed to the highest since the central bank began polling consumers in 2014. The median result of the survey of about 2,000 Canadians was for inflation of seven per cent a year from now, about five per cent in two years, and about four per cent in five years.

“Canadians think the likelihood of inflation remaining high for a long time has increased,” the report said.

Households see supply-chain issues as the biggest source of inflation (about 40 per cent), followed by the pandemic and higher government spending, each the choice of about 25 per cent of respondents. Most still think the Bank of Canada will bring inflation down, but confidence is wavering: 35 per cent of respondents said they thought the central bank would achieve its inflation target “most of the time” in the future, compared with 40 per cent at the end of 2019.

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What does it mean for interest rates?

A big part of monetary policy is psychology. If executives and consumers are confident that central banks such as the Bank of Canada will make good on their inflation targets, they will set the prices they charge for their goods and services and their wage demands accordingly. And if expectations remain anchored to the target, then central bankers won’t have to raise or lower interest rates aggressively to maintain price stability.

There’s some evidence now that inflation expectations are becoming unanchored, which could prompt Bank of Canada Governor Tiff Macklem to attempt a bigger bang in order to show skeptical Canadians that he’s serious about wrestling inflation back to the two-per-cent target, even if many of the forces putting upward pressure on prices are beyond his control.

In the United States, the Federal Reserve, which is facing even hotter inflation, increased its benchmark interest rate three quarters of a percentage point, an outsized move that underlined the worry that central bankers are losing their grip on inflation expectations. Expect the Bank of Canada to do the same when it updates policy on July 13. It could even choose to go a full percentage point.

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