Spending Shift, Business Investment to Help Inflation Fight

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Benjamin Tal, deputy chief economist, CIBC.

If you look at the overall situation, the Canadian economy is still doing relatively okay. We got very strong numbers for the first quarter and the indication is that the spring is relatively strong. We see business investment improving, the consumer is doing extremely well. That’s something that is not a big surprise. Given the pent-up demand in the market and the opening up of the economy, we see a situation in which there is a shift in consumption energy from goods to services. That’s a good thing.

It’s also less inflationary because the service sector is less inflationary in a sense that the supply is more elastic and the availability of new businesses to start and open and compete is there, relative to the goods segment of the economy. In other words, it’s much easier to start a new restaurant than to establish a new manufacturing facility and, therefore, the shift from goods to services that we are seeing now is actually disinflationary.

Nevertheless, inflation is a major, major factor impacting the economy, and there are four sources of inflation. One is energy, and I believe that this source is dying off. I believe that on a year-over-year basis, actually inflation will be a negative contributor to energy, and will be a negative contributor to inflation, and that’s actually a good thing.

At the same time, we also have the supply chain story that although is COVID-related, it will be with us for a while, especially given the complications coming from China and Russia. Therefore, we expect the supply chain story will ease, but still will be with us a year from now.

The more permanent element of inflation is the labour market. The labour market is very, very tight, more tight in the US than in Canada, therefore, wages in the US are rising faster. Nevertheless, wages are rising, will continue to rise, and that’s something that will be with us for a while. In addition, as I indicated earlier, rent is a very important factor and rent will continue to be inflationary because we simply don’t have enough supply of rental units and demand will rise.

Overall, this means that the Bank of Canada will have to raise interest rates. We expect the Bank of Canada to raise interest rates from 1% to 2.5%. That will be significant, that will slow down the economy, clearly will slow down the housing market.

At the same time, the probability of a recession is starting to rise. Every economic recession was helped, if not caused, by monetary policy error in which central bankers raised interest rates way too quickly and caused the recession. We are not there yet, but if we move from 2.5% to, let’s say, 3.5%, that can make the difference between a soft landing and a recession.

Again, that’s not our main case scenario. We believe that the reduction in inflation coming from the supply chain and the diminishing impact of energy prices on the economy means that a lot of the work on fighting inflation will be done externally and, therefore, the Bank of Canada will have to raise interest rates only to 2.5% and basically rest. But clearly there is a risk and that’s more or less where we are.

We also see something very interesting when it comes to businesses. Businesses are facing three things that in the past helped their business. What I mean by that is that if you look at the last 20 years, profit margins went up because of globalization, just-in-time inventories, and cheap and available labour.

Now everything is different. Globalization is turning into de-globalization. We have a situation in which just-in-time inventories are turning to just-in-case inventories and clearly labour is not available and not cheap. So what we see more and more companies doing is basically replacing labour with capital, exactly what we have seen in the 1990s when wages went up and inflation went down because of increased productivity, because of increase in investment.

That’s exactly what we’re starting to see now. So companies will not just sit and look at their cost structure rising. They will not just pay this higher wage. They will do something else, and this something else will be replacing labour with capital. I see more investment coming in the next year and already, if you look at previous months, we are seeing investments starting to rise. That’s something that can protect us from inflation because productivity is the number one shield from inflation.

To sum up, the economy is doing fine now. The economy will continue to do well into the summer with the consumer leading the way, utilizing the mountain of cash they are sitting on to spend on services. Services will be less inflationary and that’s a good thing. In addition, energy inflation will not be as significant in the future and the interest rates will be rising to fight rent inflation, and clearly wages and companies will be reacting to the new situation.