David George-Cosh

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The Bank of Canada outlined a potential "wage-price spiral" that could lead to a persistent - and undesirable - level of inflation over the coming years, requiring further monetary tightening to help avoid a recession.

In a breakout box listed in the Bank of Canada's Monetary Policy Report, the central bank said that a "self-reinforcing wage-price spiral" could occur and pose an upside risk to its inflation outlook.

In this scenario, the Bank of Canada said that if inflation remains high, more Canadian households and companies could base their own expectations on recent data which could lead to "de-anchored" longer-term price forecasts, keeping inflation stubbornly above the central bank's two per cent target.

If inflation expectations became de-anchored, the Bank of Canada believes that companies would set prices even higher, while workers would negotiate for persistently higher wages to protect their own purchasing power. If wage growth continues, then companies could feel inclined to raise prices even further, perpetuating the so-called "wage-price spiral", the central bank said.

"The longer inflation remains well above target, the more likely it is that a wage-price spiral will occur," the Bank of Canada said. "This likelihood also increases in firms have multi-year wage agreements in place with high wage increases in every year."

In this scenario, if inflation expectations remain high and wages ratchet even higher, the risk of a recession would rise, with the Bank of Canada modelling four straight quarters of negative economic growth through 2022 to 2023.

"The Bank of Canada is keenly aware of the possibility of a wage-price spiral and is firmly committed to ensuring that this dynamic does not set in," it concluded. "This requires setting monetary policy much tighter than in the base case to ensure that long-run inflation expectations remain well anchored."