U.S. Should Prepare for Inflation Surprise

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Avery Shenfeld

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Avery Shenfeld, chief economist at CIBC.

Inflation is on the minds of investors. More so in the U.S. than in Canada, where the spike in both the CPI as well as the core measures of inflation have been much more dramatic. But we’ve seen central bankers on both sides of the border — the U.S. and Canada — come to the conclusion that much of this is temporary. And that for now, they can afford to keep interest rates down near zero while they await for more evidence of a maturing economic recovery.

And indeed, we’re sympathetic with the view that a lot of what we’ve seen on the inflation front reflects either the fact that we’re comparing prices to relatively low prices a year ago when the economy was more in the throws of the pandemic, as well as globally some bottlenecks not only in production but in shipping that have created a shortage of goods or a shortage of components that are needed to manufacture those goods. And therefore, being met with a supply-demand imbalance: consumers want to buy, but producers are unable to deliver. And that is a recipe for a spike in inflation on autos, used cars and other goods that are in short supply.

Those imbalances could persist for a number of months, but we do believe that by early next year, we’ll see some of that inflation pressure erode.

Nevertheless, I don’t think we’ll put inflation pressures out of the minds of central bankers for good, because as we look ahead into 2022 with the economy having completed more of its recovery, we could see a return to much more normal cyclical pressures on inflation. That’s particularly likely in the U.S. ahead of Canada. The U.S. fiscal policy provided a much larger boost to American consumers’ bank accounts and pocketbooks than we’ve seen in Canada. So, there’s more spending power there to drive prices higher as a result of that fiscal stimulus. And we also think that the U.S. will be slightly ahead of Canada in attaining the kind of full employment, unemployment rates that are necessary to drive more wage inflation.

All of that suggests to us that, while inflation will be more benign in 2022 than it looks in the current year, that we won’t see it tame enough for central banks to stay on hold for that much longer into 2022.

Now, financial markets are already pricing that in for the Bank of Canada because, in its script to financial markets, the Bank of Canada is signaling that it can only pledge to keep interest rates on hold through the first half of next year. And we do see the Bank of Canada raising rates a quarter point before the end of 2022.

If there’s a surprise to financial markets, it’s going to come from the U.S., where the Federal Reserve’s message is that it sees core inflation drifting back to 2% in 2022. We see that as too optimistic. We think that core inflation will be running in the 2.5 to 3% range in 2022. And that’s going to require the Federal Reserve to bring forward the timetable for interest rate hikes, where we see two quarter-point hikes by the Federal Reserve in the latter half of 2022.

That’s not currently built into the financial market and nor is in our view the persistence of some core inflation pressures in 2022. So, we do look for bond yields to move up across North America as a result of that persistent core inflation threat in the U.S. That’s not necessarily a huge issue for the equity market. Interest rates are still going to be very low by historical standards right across the yield curve. And of course, to some extent, the signposts of that inflation upturn in the U.S. are also at the same point signposts of an economic recovery and the recovery and demand that equity markets are counting on to drive earnings growth next year.

So, inflation as a whole in the Bank of Canada’s eyes — it’s mostly a temporary situation. It’s calm about that, but 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 and the way to keep that at bay is simply put to start creeping interest rates higher when the economy no longer needs them.