Prepare for return of inflation: CIBC

Advisors may want to brush up on their history, with a close focus on the 1980s. The wholesale banking arm of CIBC is predicting a spike in inflation down the road, as policymakers around the world embrace quantitative easing in battling the economic recession.

While the threat of hyperinflation is greatest in the U.S. and Great Britain, Canadians are also at risk.

“Printing money looks to be a key ingredient in preventing a global recession from tipping into a lasting depression,” says Avery Shenfeld, chief economist, in a report released Monday.

“However, it also raises the risk that policy makers will mishandle the timetable for unwinding unprecedented amounts of fiscal and monetary stimulus, leading to run-away inflation.”

The U.S. Federal Reserve leads the pack in quantitative easing, having announced in mid-March that it would buy up over $1 trillion worth of mortgage-backed securities and longer-term treasury bonds.

The Fed is essentially printing more money to pay for these purchases, hoping that the flood of new dollars will unfreeze the credit market. While the strategy may hasten the end of the recession, the increased money supply risks devaluing existing dollars.

Battling inflation will require the Fed to raise interest rates, possibly to highs not seen since the late 1970s and early 1980s.

Related Stories

Fed’s Treasury purchases to devalue dollar Retirement’s greatest threat? BoC cuts rate to all-time low

“[With the U.S.] facing a sharp climb in government debt and a household sector similarly over-borrowed, inflation could be a tempting way to shrink the real value of those burdens,” says Shenfeld. “Even without a deliberate plan, it would be easy to err and unintentionally overdo the money pump-priming, or reverse it too late.”

While the Bank of Canada has not yet taken the same road, its governor recently said that both credit easing and quantitative easing were on the table.

“As the overnight rate approaches zero, it is important that Canadians understand that the Bank retains a considerable number of policy options to achieve its mandate,” Mark Carney told the Northwest Territories Chamber of Commerce on April 1. “To be absolutely clear, outlining a framework does not necessarily imply that these policy options will be deployed. Their use will be a function of the outlook for output and inflation and of the relative effectiveness of the instruments in achieving the inflation target.”

Shenfeld points out that the deteriorating economy will drive core inflation below the lower end of the Bank’s 1% to 3% target band before the end of 2009. He says the Bank is unlikely to cut interest rates on its own in April, and will have little choice but to buy up government bonds or other credits to lower longer term interest rates.

If a recovery takes hold, he suggests the Bank would sooner reverse course on quantitative easing and sell bonds back to the market, than raise interest rates.

“Anticipating that response, we’ve pushed back any Bank of Canada overnight rate hikes beyond our end-of-2010 forecast horizon,” he says.

In the U.S., a recovery will also result in a massive sell-off of credit instruments recently bought up by the Fed. This leaves Shenfeld bearish on the long bond market, particularly U.S. Treasuries, while Canadian sovereign debt will outperform.

As the U.S. dollar loses its value, the relative price of commodities is set to rise. Crude oil prices in particular are expected to soar, as an economic recovery drives demand. As fuel costs rise, the price of production and transportation will rise, raising consumer prices.

“The foundation of the modern agri-food system has rested on cheap energy, given the need to maximize yields in the face of constraints on arable land supply,” says CIBC Senior Economist Benjamin Tal. “But a recovery in oil prices, and the potential impact of environment policies to restrain its use, will turn this model on its head.

(04/06/09)