Can Central Banks Curb Inflation Without Causing a Recession?

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Avery Shenfeld

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Avery Shenfeld, chief economist at CIBC.

As any Canadian knows who’s filled up their gas tank or gone to the grocery store over the past year, inflation is still running much too hot for anyone’s liking. Including the Bank of Canada, which is attempting to wrestle it back down to the 2% range. We do think that we’re close to, if not already at, the peak for inflation. There are signs that gasoline prices have been moderating in July and into August. Some of the raw food commodities have also started to ease off. That would be things like grain prices, for example. Although in that case, it takes quite a while for that to show up in the box of Corn Flakes at your grocery store. But in general, we are seeing a bit of relief from inflation.

But that said, in terms of getting back to 2%, we still have a long road ahead of us. There are items in the inflation basket including things like rents, for example, that are still climbing and adjusting to this high inflation world. That suggests that The Bank of Canada is still very much on the path to raising interest rates, to slow economic growth in order to ensure that it’s not just gasoline inflation that disappears, but really the broader pressure on consumer prices in Canada.

The result is that we do think that interest rates will likely rise another three quarters of a percent or so from where they stood as of early August. We may get that all in one lump in September if the Bank of Canada decides it’s important to get there in a hurry. That would leave the overnight benchmark interest rate at roughly three and a quarter percent, still possible that we get as high as three and a half. That should be enough to slow economic growth in Canada and help moderate the inflation environment into the coming year.

Similar story in the U.S. Inflation has been even higher, but we did see in the data that was reported for the most recent month, which would cover July, that there is of course, some falling prices for things like gasoline, but also a little bit of a moderation in prices for clothing and other goods that had soared in the prior year. There too, rent is an important and still rising component of the inflation picture in the U.S. as more people’s rents come up for renewal. So they’re not by any means out of the woods yet.

So the risk for investors is that if inflation doesn’t come down fast enough, we get the central banks deciding to layer on more and more heat. They take interest rates not to three and a quarter or three and a half, but somewhere closer to 4%. In the past, that’s often been the cause of an outright recession, is that slight miscalculation or a little bit overly aggressive policy at the central banks can turn what they’re aiming for, which is a year or two of slow growth and turn that into an outright recession. That’s why investors have to think about balancing the risks in their portfolio, not having too much of their assets in the kind of equities that depend on an economy growing more quickly, not too much exposure to the kinds of sectors that would be hit hardest in a recession.

Now, there are some opportunities in this. The most plain vanilla types of investments, things like five year GICs, for example, are now finally paying a reasonable rate of interest. Doesn’t look good relative to inflation, but we don’t expect inflation to average four or 5% over the next five years. So if we do get inflation back to 2% in the coming year, that should give you a reasonable after inflation return when you look out over a full five year horizon.

Then there are still items in the equity basket where there are companies that aren’t that exposed to the business cycle that are now after the period of somewhat weaker equity performance, paying a reasonable dividend. And they too represent reasonable investment opportunities for investors in this still quite uncertain climate of high inflation and central banks trying to slow economic growth as a result.