Don’t Expect a Smooth Path for Inflation

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Avery Shenfeld

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Avery Shenfeld, chief economist at CIBC.

We’d all like to see lower inflation numbers and if we’re willing to be patient, I do believe those are coming particularly by the second half of 2023. But the path from here to there is not exactly a smooth one because we’re facing the intersection of some prices that will be, in fact, outright declines. Others where the rate of inflation will be cooling, but still other parts of the economy in both the U.S. and Canada that could see a persistence of elevated inflation for a while.

On the last front, where we’re seeing that, particularly in the U.S., is on rents. Remember that if rents jump in the overall market, not everyone has their rent come up for renewal in any one month. So some of the Americans and Canadians saw rent increases back when their lease came up, say in February, whereas there’d be other people whose leases are coming up in November and are going to see that same increase that will continue to feed into the CPI.

So there are some areas like that where we expect both in rents as well as some services where demand is picking up as the pandemic concerns fade, where we can continue to see some upward pressure on prices. We’re also seeing wages running at a fairly elevated cliff to some extent in response, not only to the tightness of labour markets, but also to the earlier inflation that we saw. There is a tendency for wages to play catch up to inflation that has happened earlier. So I don’t suspect that in labour-intensive industries, for example, where those pay increases are a big part of the cost structure, we’re not going to get that much relief on the inflation front that soon.

That said, the precursors of some softer inflation for 2023 are already starting to show up. For one, world energy prices have come down, particularly for oil, although we do expect the price of oil to stabilize at around $90 a barrel, there’ll be some points in 2023, for example, where that represents a big decline from where oil was at the same point in 2022.

And as a result, gasoline prices, which remain a bit elevated, will be a lot lower in 2023 on average than they were in 2022. Turning that part of the CPI to a big negative. Food prices aren’t likely to plunge, but they do show some signs in raw agricultural products of at least leveling off. So again, food inflation could melt away fairly quickly in the first half of 2023, going from a big positive number to something close to flat. But we’ll need a longer period of sluggish economic growth to deal with those broader inflation issues both in wages and in services prices. We expect that a year of negligible growth in 2023 will mean that by late 2023, the overall basket in the CPI will be running close to the Bank of Canada’s 2% target.

Now, it will be important for the Bank of Canada to avoid cutting interest rates too abruptly or governments providing a lot of fiscal stimulus that causes the economy to take off because you can’t rule out a reheating of inflation in 2024 if we were to again visit very low unemployment rates and very tight economic conditions. So while we do expect inflation to look a lot lower at some points in 2023, to keep it there over the medium term, we’ll likely need to see a continuation of relatively disappointing growth for at least another year into 2024.

The good news is that we don’t seem to be where we were in the early 1980s. While we continue to see headlines suggesting that we’re now seeing the highest inflation we’ve had since the early 1980s, there are some important differences. In the early 1980s, inflation had been on a gradual upward creep since the late 1960s. So inflation was not only elevated, but expected to remain elevated for the following decade. It meant that getting inflation down was dealing with entrenched expectations, which makes it much more difficult to do that. We’re not in that position now. And a bit more of the inflation we’ve seen this time around isn’t rooted in excess demand in the economy, but rather in difficulties in the global supply chain in responding to that demand. And we are hopeful that while not all the ills of the world of supply chains will be cured in a single year, that by this time next year we will be able to produce some additional vehicles, putting some downward pressure on vehicle prices, that supply chains coming from China might improve a bit if the zero-COVID policy there can be relaxed at all.

So there’s some signs that perhaps a bit of progress on getting more good supply to the global economy can also take some of the wind out of the inflation that we’re seeing now in a way that in the early 1980s that wasn’t really the option. At that point, we really needed a very large recession to get inflation under control.

So don’t expect to see in summary a very quick turn to the kind of 2% inflation world that we’re hoping for, but do expect that by this time next year the surprises in inflation are likely to be on the downside and that we’ll be seeing a bit of a sigh of relief in financial markets at that point that we didn’t need to go through a kind of early 1980s punishing recession to get inflation back under control.