Canada’s declining productivity contributes to inflation problem

Canada's declining productivity contributes to inflation problem

Canada’s Declining Productivity Poses Challenges for Bank of Canada

Toronto, Sept 21 (ANBLE) – Canada’s record of declining productivity over the past three years is likely to make it more difficult for the Bank of Canada to tame inflation, raising the prospect of additional interest rate hikes even as the economy slows.

The Canadian central bank had expected productivity, or output per hour worked, to improve as the economy recovered from the COVID-19 pandemic. Instead, it has fallen in eleven of the last 12 quarters, taking it back to its 2016 level. This trend of declining productivity does not bode well for economic growth and could add upward pressure to unit labor costs, a key measure of inflation pressures arising from higher wages.

The Challenge of Weak Productivity Growth

“Weak productivity growth has been a serial problem in Canada,” says BoC Governor Tiff Macklem. Despite keeping the benchmark interest rate at a 22-year high of 5%, the central bank acknowledged the prospect of slower economic growth. Macklem notes, “Our own forecast is that productivity growth will turn around, but that is a risk to the outlook, and if productivity growth continues declining, it will make it more difficult to get inflation back to target.”

The central bank has projected that inflation will return to its 2% target by the middle of 2025. However, recent data revealed that inflation rose more than expected to 4% in August, driven by higher gasoline prices. Additionally, wage growth accelerated last month to an annual rate of 5.2%. This increase in wages does not reflect a corresponding increase in productivity, as output per hour worked has been on a downward trajectory.

Rising Unit Labor Costs and Tough Choices Ahead

Derek Holt, head of capital markets economics at Scotiabank, points out that rising unit labor costs present a dilemma for the economy. Businesses must either reduce headcount to protect profits or face further tightening of monetary policy. Rapid wage gains without corresponding productivity growth are not sustainable in the long term.

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The market has priced in another rate increase by the Bank of Canada in the coming months. However, a switch to easing is expected by the end of 2024, albeit at a slower pace than that of the Federal Reserve.

Canada’s Investment and Productivity Conundrum

Record levels of immigration have boosted Canada’s economic growth, but per capita GDP has grown much more slowly compared to the United States. “We have been substituting labor for capital. So we bring more people in, or we run our plants harder,” says Dennis Darby, president and CEO of Canadian Manufacturers & Exporters. This approach has its limitations, as Canada currently trails behind other G20 countries in terms of investment.

According to a June report by the Fraser Institute think-tank, Canadian businesses invested 55 cents per worker for every dollar invested per worker in the United States in 2021, down from 79 cents in 2014. This underinvestment in capital has contributed to the country’s productivity struggles.

Structural factors also impede productivity growth in Canada. These include the significant geographical size of the country, leading to increased transportation costs, a higher proportion of small businesses that tend to invest less, and the presence of oligopolies that reduce competition in industries such as banking and telecommunications.

Consequences of Zero Productivity Growth

With productivity growth stagnant in recent years, concerns arise that all wage gains will find their way into prices. Doug Porter, chief economist at BMO Capital Markets, highlights this issue, stating, “The big concern is that with productivity printing a big, fat zero growth in recent years, the entirety of wage gains is likely to find its way into prices.”

Addressing the declining productivity trend in Canada will require concerted efforts from policymakers, businesses, and individuals alike. Investing in infrastructure, promoting innovation, and supporting education and skills development are key priorities to revive productivity growth. By addressing these challenges head-on, Canada can create a more productive and prosperous economy for the future.

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