Bank of Canada surveys show rising inflation expectations, increasing chance of hefty rate hike

Bank of Canada surveys show rising inflation expectations, increasing chance of hefty rate hike thumbnail

People shop at a Walmart Supercentre in Toronto on March 13, 2020.CARLOS OSORIO/Reuters

Canadian consumers and businesses expect inflation to remain high for several years, adding pressure on the Bank of Canada to announce another oversized interest rate increase next week to prevent rapid consumer price growth from becoming entrenched.

A pair of quarterly surveys published by the Bank of Canada on Monday, one focused on consumers and the other on businesses, show that high inflation is increasingly becoming baked into Canadians’ psychology. Short-term inflation expectations among consumers are at a record high, while businesses expect inflation to remain elevated as they grapple with labour shortages, rising wages and supply chain bottlenecks.

The surveys may provide additional impetus for the Bank of Canada to increase its benchmark interest rate by 0.75 percentage points at its July 13 rate decision – which would be the biggest single increase since 1998. Central bank officials have said during recent public appearances that keeping a lid on inflation expectations is their most important near-term task, and that they are prepared to “act more forcefully” if needed.

Inflation expectations are a major determinant of actual price increases. Workers demand higher wages and businesses set higher prices based on where they think inflation is heading. That can lead to a wage-price spiral, which can make inflation self-reinforcing – a situation the Bank of Canada is desperate to avoid.

“The longer inflation remains well above our target, the more likely it is to feed into inflation expectations, and the greater the risk that inflation becomes self-fulfilling,” Bank of Canada deputy governor Paul Beaudry explained in a speech last month.

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“History shows that once high inflation is entrenched, bringing it back down without severely hampering the economy is hard. Preventing high inflation from becoming entrenched is much more desirable than trying to quash it once it has.”

The annual rate of inflation in Canada hit 7.7 per cent in May, the highest since 1983.

The consumer survey, conducted from late April to mid-May, found that the median respondent expects the rate of inflation to be nearly 7 per cent next year and around 5 per cent in two years. That’s far above the central bank’s 2-per-cent inflation target.

Perhaps more concerning for the Bank of Canada is the fact that long-term consumer inflation expectations are rising after remaining well contained over the past two years. Respondents expect 4-per-cent inflation in five years’ time. That’s up from 3.2 per cent in the previous consumer survey, published in April.

The central bank noted in the survey publication that inflation concerns differ across demographics. Lower-income Canadians and older people tend to be more worried about rising rent and grocery prices, while younger people are more likely to be worried about home prices.

The survey found that Canadians don’t expect their wages to keep pace with inflation, and that many people, particularly those with low incomes, are already changing their spending habits and postponing major purchases.

“People now frequently shop around to find better prices, and they stockpile items that are on sale. Some consumers mentioned sticking to a strict budget for groceries by buying more generic products or not buying items deemed less necessary. Some are relying more on gardening for food or using cheaper forms of commuting, like biking,” the Bank of Canada noted.

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There was a potential bright spot: the central bank said trust in its ability to achieve its 2-per-cent inflation target has not changed materially compared to before the pandemic, despite the surge in inflation. Around 42 per cent of respondents thought the Bank of Canada could achieve its inflation target all of the time or most of the time, compared to around 45 per cent in 2019.

The survey of businesses, conducted from mid to late May, found that nearly one-third of respondents think inflation will remain substantially above 2 per cent for two to three years, while a further 22 per cent think it will remain high for three or more years.

Businesses are dealing with significant labour shortages, as well as ongoing supply chain constraints, and plan to pass higher input costs along to customers. These are signs that there is “excess demand” in the economy, the Bank of Canada said in the survey publication.

Forty-two per cent of businesses said they are struggling to find enough workers to meet demand for their products and services. Many are responding by increasing compensation: survey respondents expect to raise wages by an average of 5.8 per cent over the next year, a record high.

“A growing number of businesses mentioned the rising cost of living as an important source of wage growth. Nearly half of firms anticipate their wage increases will remain above pre-pandemic levels beyond the next 12 months,” the Bank of Canada said.

The surveys add to the argument for an aggressive rate hike next week by the Bank of Canada, according to Bank of Montreal economist Shelly Kaushik.

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“Inflation pressures remain historically high, though there are some indications that resilient consumer demand can help businesses weather the increasingly cloudy outlook,” Ms. Kaushik wrote in a note to clients.

“Still, the persistence of rising inflation expectations only reinforces our expectations for a 75 [basis point] hike at next week’s policy meeting.”

The bank has increased its policy rate at three consecutive meetings, including two 50-basis-point moves. The benchmark rate is currently at 1.5 per cent. Central bankers have said they may need to move it to 3 per cent or above to get a handle on inflation.

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