Jobs and Inflation: The Missing Link

There seems to be a consensus that the Bank of Canada will raise its target interest rate tomorrow. I thought that last month’s rate hike was premature, so I see no reason for another hike this month.

The argument for higher interest rates is that they are needed to ward off future inflation (even though inflation is currently below the Bank of Canada’s target). In particular, many economists have been pointing to strong employment numbers as presaging inflation. But they have not really explained how more jobs would cause higher prices.

One possibility is that more employment means more income and consumer spending, which would drive up prices. However, most goods that Canadians buy are traded on world markets. Since our market is relatively small, we can always import more without appreciably affecting global prices.

For example, if Canadians buy more cars, that would not drive up car prices. Conversely, there are so many more Americans that their car buying could increase car prices and hence inflation. But the US job numbers have been weaker. The American Federal Reserve is certainly not hiking interest rates for fear of inflation.

Of course, some things cannot be imported. Since there is a limited supply of real estate within Canada, more demand for housing can drive up housing prices. However, increased employment is not boosting housing demand. If anything, our real estate market appears to be slowing.

Wages are another possible link between jobs and inflation. The usual story is that a tight labour market leads to higher wages and hence higher prices. Wages are particularly relevant to service prices, which largely reflect the cost of employing Canadian workers to provide services.

However, job creation coming out of a recession has not produced a tight labour market. While Canada added 372,000 jobs over the past year (June 2009 – June 2010), some 270,000 more people joined the labour force, so unemployment fell by only 102,000.

There are still 1.5 million unemployed Canadians who could be hired without bidding up wages. Indeed, despite strong employment growth over the past year, the average hourly wage rose just 1.7%. There is no evidence of a tight labour market generating inflationary wage pressure.

Of course, since monetary policy operates with a lag, a more relevant question might be whether Canada is likely to have a tight labour market a year from now. Imagine that we repeat our blockbuster performance over the next year.

With another 372,000 new jobs and 270,000 more people joining the labour force, 1.4 million Canadians would remain officially unemployed. The national unemployment rate, now 7.9%, would go down to 7.3%. That is still well above the 6% unemployment we had before the crisis.

Canada’s job market is getting better. But it is nowhere near the point where labour shortages and big wage gains could propel inflation.

UPDATE (July 20): Quoted by Canadian Press and The Toronto Star