- The rise in inflation and the sluggish response of wages so far implies that household purchasing power will fall 3% over the next three years. This is expected to lead to a cumulative decline in real GDP of 0.6% over that time, along with a reduction of 1.4% in real consumption, and an associated reduction in imports.
- If inflation rises more than we are forecasting we should expect, other things being equal, lower GDP growth. This negative risk on the output gap is not a negative risk on the policy rates as the increase in inflation would dominate the fall of the output gap in the reaction function of the BoC.
Recently, inflation has outpaced the growth of wages, leading to a loss of purchasing power. In a recent note, we estimate that household purchasing power will fall by 3% in the next year or two (see chart). We also forecast that wage growth will be catching up starting in 2023 to start to close this wage gap and eventually restore purchasing power by the end of 2025/beginning of 2026. Using the Scotiabank Global Macroeconomic Model, we find that the expected deterioration of purchasing power, through its effect on disposable income, will reduce GDP and consumption growth by a cumulative 0.6 percentage points and 1.4 percentage points, respectively, over the next three years. The biggest effect will be in 2023, reducing GDP growth by 0.3 percentage points.
1) METHODOLOGY AND RESULTS
In our model, a reduction of the wage gap (wage minus prices and productivity in logs) negatively affects household disposable income. In turn, disposable income positively affects consumption and therefore GDP. Consequently, if inflation outpaces wage growth, disposable income, consumption and GDP will be temporarily lower. Other drivers of disposable income include potential GDP, the unemployment rate, the long-term interest rates and the government deficit/GDP ratio.
We use the Scotiabank Model to forecast the Canadian economy. Therefore, it is possible to measure the contribution of the wage gap to consumption and GDP growth by simply turning off the channel of the wage gap on disposable income. We then compare the profile of GDP and consumption given by this modified forecast with our base case which includes the effect of the wage gap. Thus, the difference between the two forecasts is the contribution of the variations of the household purchasing power on the forecast. Results are shown in Tables 1 and 2. According to our model, the expected loss of household purchasing power will reduce annual GDP growth by -0.2 percentage points in 2022, -0.3 in 2023 and -0.1 in 2024. This corresponds to a cumulative 0.6 percentage fall of GDP over the next three years which is not negligible. One might have expected a larger negative effect, but three factors contribute to reduce the effect of the fall of purchasing power on real GDP:
i) First, although persistent, the fall of purchasing power is temporary as opposed to permanent.
ii) Second, part of the loss of purchasing power shows up in a reduction of savings as opposed to a drop of consumption and therefore GDP.
iii) Third, an important share of the fall of consumption is in fact a fall of imported goods which contributes to partly offset the effect on GDP.
2) POLICY IMPLICATIONS
Nevertheless, the loss of purchasing power will reduce GDP growth in the forthcoming years. It is worth noting that if inflation is higher than currently forecast, we should expect, other things being equal, lower GDP growth because of the wage gap channel on disposable income. However, this negative risk on GDP is not a negative risk on our profile of the Bank of Canada’s policy rate because the increase of inflation would dominate the fall of the output gap in the reaction function of the BoC.
DISCLAIMER
This report has been prepared by Scotiabank Economics as a resource for the clients of Scotiabank. Opinions, estimates and projections contained herein are our own as of the date hereof and are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. Neither Scotiabank nor any of its officers, directors, partners, employees or affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents.
These reports are provided to you for informational purposes only. This report is not, and is not constructed as, an offer to sell or solicitation of any offer to buy any financial instrument, nor shall this report be construed as an opinion as to whether you should enter into any swap or trading strategy involving a swap or any other transaction. The information contained in this report is not intended to be, and does not constitute, a recommendation of a swap or trading strategy involving a swap within the meaning of U.S. Commodity Futures Trading Commission Regulation 23.434 and Appendix A thereto. This material is not intended to be individually tailored to your needs or characteristics and should not be viewed as a “call to action” or suggestion that you enter into a swap or trading strategy involving a swap or any other transaction. Scotiabank may engage in transactions in a manner inconsistent with the views discussed this report and may have positions, or be in the process of acquiring or disposing of positions, referred to in this report.
Scotiabank, its affiliates and any of their respective officers, directors and employees may from time to time take positions in currencies, act as managers, co-managers or underwriters of a public offering or act as principals or agents, deal in, own or act as market makers or advisors, brokers or commercial and/or investment bankers in relation to securities or related derivatives. As a result of these actions, Scotiabank may receive remuneration. All Scotiabank products and services are subject to the terms of applicable agreements and local regulations. Officers, directors and employees of Scotiabank and its affiliates may serve as directors of corporations.
Any securities discussed in this report may not be suitable for all investors. Scotiabank recommends that investors independently evaluate any issuer and security discussed in this report, and consult with any advisors they deem necessary prior to making any investment.
This report and all information, opinions and conclusions contained in it are protected by copyright. This information may not be reproduced without the prior express written consent of Scotiabank.
™ Trademark of The Bank of Nova Scotia. Used under license, where applicable.
Scotiabank, together with “Global Banking and Markets”, is a marketing name for the global corporate and investment banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, including; Scotiabank Europe plc; Scotiabank (Ireland) Designated Activity Company; Scotiabank Inverlat S.A., Institución de Banca Múltiple, Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Casa de Bolsa, S.A. de C.V., Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Derivados S.A. de C.V. – all members of the Scotiabank group and authorized users of the Scotiabank mark. The Bank of Nova Scotia is incorporated in Canada with limited liability and is authorised and regulated by the Office of the Superintendent of Financial Institutions Canada. The Bank of Nova Scotia is authorized by the UK Prudential Regulation Authority and is subject to regulation by the UK Financial Conduct Authority and limited regulation by the UK Prudential Regulation Authority. Details about the extent of The Bank of Nova Scotia's regulation by the UK Prudential Regulation Authority are available from us on request. Scotiabank Europe plc is authorized by the UK Prudential Regulation Authority and regulated by the UK Financial Conduct Authority and the UK Prudential Regulation Authority.
Scotiabank Inverlat, S.A., Scotia Inverlat Casa de Bolsa, S.A. de C.V, Grupo Financiero Scotiabank Inverlat, and Scotia Inverlat Derivados, S.A. de C.V., are each authorized and regulated by the Mexican financial authorities.
Not all products and services are offered in all jurisdictions. Services described are available in jurisdictions where permitted by law.