U.S. should prepare for inflation surprise

One of the most persistent debates among investors this year has been the extent to which inflation should worry investors.

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Supply-demand imbalances, as well as the fact that current prices are being compared to low prices a year ago when the economy was in the throes of the pandemic, have caused a spike in the consumer price index and core measures of inflation in both the U.S. and Canada.

While central bankers on both sides of the border have concluded that rising prices are temporary, CIBC’s chief economist sees policymakers raising interest rates next year.

As the economy continues to recover in 2022, “we could see a return to much more normal cyclical pressures on inflation,” particularly in the U.S., said Avery Shenfeld in an Aug. 12 interview.

“The U.S. fiscal policy provided a much larger boost to American consumers’ bank accounts and pocketbooks than we’ve seen in Canada,” he said. “So, there’s more spending power there to drive prices higher as a result of that fiscal stimulus.”

Shenfeld said he also thinks the U.S. will be slightly ahead of Canada in attaining the employment and unemployment rates necessary to drive wage inflation. 

“All of that suggests to us that, while inflation will be more benign in 2022 than it looks in the current year, we won’t see it tame enough for central banks to stay on hold for that much longer,” said Shenfeld, who was speaking before the latest GDP reading showing the Canadian economy contracted in the second quarter.

Speaking at the Jackson Hole Economic Symposium last week, Fed Chair Jerome Powell said there’s been “clear progress” toward the Fed’s goal of maximum employment. He also said that inflation has risen enough to meet the test of “substantial further progress” toward the Fed’s goal of 2% annual inflation over time as he signalled the central bank would likely begin tapering its bond purchases this year.

The Bank of Canada (BoC) has said it doesn’t see a need to raise interest rates before the second half of next year and Federal Reserve policymakers have pointed to a late-2023 hike. The Federal Reserve’s message is that core inflation will drift back to 2% in 2022, but Shenfeld said that’s “too optimistic.” He sees U.S. inflation running closer to 2.5% or 3%. 

“If there’s a surprise to financial markets, it’s going to come from the U.S.,” he said. 

Higher core inflation will force the Fed into two quarter-point hikes in the second half of 2022, he said — and those hikes aren’t built into financial markets. He also sees bond yields rising in Canada and the U.S.

“That’s not necessarily a huge issue for the equity market,” Shenfeld said. “Interest rates are still going to be very low by historical standards right across the yield curve. And, to some extent, the signposts of that inflation upturn in the U.S. are also signposts of an economic recovery,” which equity markets are counting on to drive earnings growth next year. 

While the Bank of Canada sees inflation as mostly temporary, he said. “it does understand that as the economy continues to improve, we start to get into the point where there’s a normal cyclical threat to inflation.”

The way to keep that at bay is “to start creeping interest rates higher,” he said.

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