Inflation more of a worry in the U.S.

Life as a central banker may be getting more complicated, as the U.S. Federal Reserve struggles to cope with both a weakening economy and the possibility of resurgent inflation. This week provided a glimpse into the discussion around the table at the last meeting of Federal Open Market Committee and it appears inflation fears have returned.

“All participants found the elevated readings on core inflation of recent months to be of concern, and if sustained, inconsistent with the maintenance of price stability,” said the summary minutes from the June meeting of the FOMC.

In his second day of testimony before Congress, Federal Reserve Board chair Ben Bernanke said that inflation was “no illusion” and that he was reluctant to rely on core inflation figures which strip out food, shelter and gasoline.

Core inflation hit 0.3% in June, which, if it persists, would translate into an annualized rate of more than 3.6%. This is much higher than the unofficial target the Fed is believed to have set at 2%. Lower energy prices in June actually helped keep overall inflation down to 0.2%.

In Canada, inflation declined in June to an annualized rate of 2.5%, down from 2.8% in May. The Bank of Canada has already indicated that it would take a break from its credit tightening program, and this slip in inflation could cement that decision at least for the near term.

But not everyone is convinced that Canada is immune to inflation.

“We’re in a part of the business cycle where the risk of higher inflation is going to be a fact of life for a few more years, at least until the next recession and I don’t anticipate that for some time yet,” says John Johnston, chief strategist at The Harbour Group, RBC Dominion Securities. “Usually you need a major inflation problem to trigger that, and right now we only have a moderate inflation risk.”

The source of that risk is two-fold, he says. First, excess capacity is ebbing, as employers struggle to find workers even in the manufacturing sector, which has been battered by the soaring Canadian dollar.

Such a situation can tip the balance of pricing power in favour of the employees. To compensate for higher labour costs, employers must raise the price of their products and services.

A second driver of inflation, Johnston says, is the “outsized” increase in the cost of energy since 2002. Much like the energy crunch of the 1970s, consumers are already feeling the pinch at the gas pumps. Eventually costs will trickle down not only through the increased price of product transportation, but also in the manufacturing of products made from petroleum, such as plastics and nylon.

“We’re looking at one of the biggest increases in energy prices in history,” he says. “It’s in line with what we saw in the 1970s, which ultimately was a period of rising inflation and very considerable distress for the economy, its workers and investors.”

So far, global outsourcing of manufacturing has helped to stave off these price increases by utilizing cheap labour in Asia, but with these economies rapidly developing, labour costs are seen rising on a global scale.

“Headline inflation for the past two years has been between 1% and 3%,” says Guy Le Blanc, portfolio manager of the Bissett Bond Fund. “When you consider that we have oil prices that have tripled over the last two or three years, it shows that globalization works, when it comes to inflation. There’s still ample manufacturing capacity that is not used globally.”

Even after three years of strong economic growth and soaring energy prices, he points out that inflation in Canada is safely within the Bank of Canada’s upper limit of 3%.

While overseas manufacturing has driven down the price of many consumer goods, the strong Canadian dollar has made imports even cheaper. Le Blanc says the corresponding depreciation in the U.S. dollar has contributed to the return of inflation south of the border.

“I think the Bank of Canada taking a pause last week shows that they are not very concerned about inflation,” Le Blanc says. “I think inflation is going to come down to 2% next year. I don’t think inflation will go to 3.5% or 4%.”

While the Federal Reserve must strike a balance between inflation and economic stagnation, the Bank of Canada must guard against further currency appreciation, because of its damaging effects on the manufacturing sector.

“The bank has more to lose in credibility by losing sight of inflation — they would lose a lot,” say Le Blanc. “I think they want to use the go-slow approach. They just had to mention that they were done raising rates and the Canadian dollar stopped going up. The bank is in the position where it can raise or cut rates if they fell they have to.”

The upside of the inflation story is that the U.S. economy is now seen to be cooling, which should in turn dampen growth in Canada.

“North American growth rates are going to be lower in the coming year than they have in the past year,” Johnston says. “Because of the strength from the past year, inflation is going to be higher. The question is, are we looking at a major stagflation problem, or more of a natural occurrence? I think it’s a natural occurrence.”

He says central banks will be on “inflation watch” for the next several years, leaving them little room to cut rates, should their respective economies require stimulus.

“If these guys do their jobs, we won’t have an inflation problem, but we will have the interest rates that prevent it,” Johnston says.

He predicts the Fed will raise rates once more in August, with the credit cycle pausing before a slowing economy leads both the Fed and the Bank of Canada to trim rates in early 2007.

Johnston says the overall environment favours equities and even cash, with short-term bonds trumping longer bonds on the fixed income side.

“The short end of the yield curve — 30 day to 365 day paper — offers you the same higher yields without taking on a lot of duration risk,” he says.

For those who absolutely feel the need to lock into a long-term bond, Johnston says real return issues may be the way to go, but that real return bonds should generally be avoided going into an economic slowdown.

Le Blanc agrees that the short end of the curve is currently a smarter move, as long-term rates do not reward investors for locking in.

He admits that his record on real return bonds could be better, as he misjudged consumer demand for them since 2002, missing much of their capital gains, but he stands by his reasons for underweighting his exposure to them.

“Below 2% [inflation] you are not really getting paid,” he says. “If inflation averages 2%, and real yields are around 1.9%, that means you’re going to earn about 4% for the next 20 years, because most of the real yield bonds in Canada have longer maturity. You have to be really afraid of inflation to buy them.”

Many investors see real return bond investments as being virtually risk free, but there is always a risk. While the yield may be guaranteed to outpace inflation, investors could easily lose on the capital side if market sentiment shifts toward a low inflation bias. Not wanting to take a haircut on the bond’s value, the investor may find themselves virtually locked in for the duration of the bond.

Le Blanc agrees that there is little incentive to buy long bonds right now, unless the investor seriously expects a major slowdown in the economy which would force a return to drastic rate cuts.

“Two years ago, one year T-bills were not even an option, they were yielding something like 2%,” he says. “Now the curve is so flat that if you want to avoid risk, you can buy two to five year bonds and you know you’re going to get 4% or 4.5% return over the next few years.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/21/06)

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