Bank of Canada headquarters

Labour markets didn’t start the latest episode of high inflation, but they are now sustaining it. And those pressures will need to recede for inflation to return to central bankers’ comfort level, according to new research from the Bank of Canada.

The central bank’s analysts examined the factors that sparked inflation in the wake of the onset of the pandemic in early 2020. Their paper found that Canada and the U.S. have been on similar rides: supply shocks in 2021 and early 2022 initially touched off inflation, and labour markets weren’t much of a factor.

One notable difference was that food-price shocks played a more important role in Canada’s inflation than in the U.S., the paper noted.

In both markets, as supply chain disruptions have faded, wage pressures have taken over.

“[E]levated wage growth seen recently in Canada has been driven by a roughly equal mix of a strong demand for labour and other price shocks that have contributed to a rise in short-run inflation expectations,” the paper said. “Labour market pressures may need to ease further to ensure that inflation returns to the 2% target by the end of 2025.”

The paper warned that “inflation could become stuck around 3% over the forecast horizon if the labour market reverts to and remains at conditions seen in 2023.”

The Bank of Canada’s research is part of a joint effort by 11 central banks — including those of the U.S., England, Japan and Europe — to understand the ongoing economic fallout from the pandemic.

“The surge in inflation experienced during the pandemic has highlighted the importance of better modelling developments in the labour market, which is a key supply-side element of the economy,” the paper said, adding that the BoC is continuing research to improve policymakers’ understanding of inflation drivers.

The paper applied a model developed by Ben Bernanke, former head of the U.S. Federal Reserve Board, and Olivier Blanchard, an economist and professor at the Massachusetts Institute of Technology, to analyze inflation across various economies.