Douglas Porter

December 10, 2021

Markets took a one-way trip north this week, with equities, yields, oil prices and related currencies all forging higher. Investors took the early read on Omicron—the very early read—and ran with it. With suggestions that vaccines are still largely effective against the new variant and some indications it is less deadly, albeit with greater transmissibility, markets swiftly brushed off the mini-correction of the past two weeks. Attention immediately reverted to the prior big concern—inflation, supply pressures, and the implications for rates.

The main message is that inflationary gales remain intense, even with the pullback in energy costs from their November highs. That month’s U.S. CPI, the marquee economic release of the week, did nothing to calm the waters, with headline inflation meeting high expectations at 6.8% y/y, and core hot at 4.9% y/y. With some tough comparisons in coming months, we don’t believe the peak has been reached on either measure just yet.

The stubbornly strong inflation backdrop reinforces our view that the Fed will begin to accelerate the proceedings. Next week’s FOMC is likely to see a doubling in the pace of tapering, ending in March, and thereby setting the stage for rate hikes by around mid-year. At this point, we would look for a series of quarter-point hikes per calendar quarter until we are back above 2% by mid-2024. The risks to this call are faster and ultimately higher, depending on precisely how the inflation dynamics unfold in coming months.

We are well above the latest consensus on the call for U.S. inflation next year (both headline CPI, which we now expect to average 5.1%, and on the core PCE deflator, where we look for 3.8% average inflation in 2022). The persistence of such meaty figures well into next year should put to rest the contention that the current lofty readings are somehow a statistical quirk. Also note that since February 2020, the overall CPI has now risen at a 4.4% annualized pace while core has plugged along at a 3.5% clip.

While there wasn’t a lot more on the U.S. data plate this week, two second-tier indicators pounded home the message of labour market tightness. Job vacancies ballooned back above 11 million in October, while initial jobless claims plunged to 184,000, the lowest since 1969. To put the vacancy tally into perspective, there are now fewer than 7 million people officially reported as unemployed stateside. So, there are 1.6 vacant jobs per unemployed person, a ratio that is literally off the charts.

Given the sudden deep drop in claims and the piping demand for workers, it’s quite possible the official jobless rate could soon careen sharply lower (currently 4.2%). If it breaks through the pre-pandemic low of 3.5%, it could then be testing levels not seen since the early 1950s. To be sure, the employment rate has still got a long way to go before it is nursed back to full health; but, Fed policy must be guided by the tightness of the job market, and it now appears to be very tight indeed.

The Bank of Canada is seemingly already on the 2022 launchpad, having dispensed with QE in late October. However, this week’s rate announcement did not advance the timeline. With markets previously priced for solid odds of a rate hike as soon as January, the placeholder remarks actually shaved short-term GoC bond yields this week, even as U.S. yields backed up notably across the curve. Thus, Canada-US 2-year spreads have been clipped to 30 bps from as high as 60 bps just six weeks ago. This narrowing in the market’s perception of relative rate hikes is, in our view, entirely appropriate. After all, next week’s CPI is likely to show Canada’s inflation rate is roughly 2 points below the U.S., and Canadian GDP is yet to return to pre-pandemic levels (while the U.S. is 1.3% above that measure).

Even so, we now look for the Bank to begin hiking in April, unleashing back-to-back-to-back moves, before also settling into a quarter-point per calendar quarter pattern. Thus, on balance, we are now calling for 100 bps of rate hikes by the BoC in 2022 (a bit below current market pricing) and 75 bps in total from the Fed (a snick above market pricing).

Inflation is even likely to be a feature topic in next Tuesday’s Fiscal Update from Finance Minister Freeland. (The fiscal side of things may be unrevealing, as Ottawa has mostly been eager to spend the revenue windfall from strong incomes; note that revenues have pretty much fully recovered, and it is spending that is far out of line with historical norms.) With the renewal of the inflation mandate to be unveiled on Monday morning, and BoC Governor Macklem speechifying on Wednesday, inflation will loom large in the update. Media reports suggest that the current 1%-to-3% target regime will be maintained, with a nod to some language on the importance of employment in reaching that target. That sounds very close to what consensus was expecting and is really no different from current practices.

Perhaps most importantly is that it appears the Bank has decided to not follow the Fed’s lead on inflation averaging. After all, with U.S. core inflation now tracking well above 2% on a five-year basis, the Fed should already be pulling the tightening lever even under their new supposed milder targeting regime.

We now have a little more insight into what prompted Chair Powell to suddenly amp up his concern on the inflation front at his Senate testimony, and to alert markets to an acceleration of tapering at next week’s FOMC.

In honour of the 50th anniversary and revival of Jesus Christ Superstar, here’s an unidentified Fed Governor advising Powell prior to the testimony:

Too Much QE on Their Minds

(Loosely based on “Heaven on Their Minds”)

My mind is clearer now.
At last all too well
I can see where we all soon will be.
If you strip away food & gas from the core,
You will see where CPI soon will be. Jay P!
You’ve started to believe
The things they say of you.
You really do believe
This talk of short-lived is true.
And all the good you’ve done
Will soon get swept away.
QE’s begun to matter more
Than the things you say.

Listen Jay P I don’t like what I see.
All I ask is that you listen to me.
And remember, I’ve been your right hand man all along.
You have set prices all on fire.
They look to have found a new range higher.
And they’ll hurt you when they find we’re wrong.

I remember when this whole thing began.
No talk of transitory then, we called it a plan.
And believe me, my admiration for you hasn’t died.
But every word you say today
Gets twisted ’round some other way.
And they’ll hurt you if they think prices won’t slide.
Washington, your famous son should have stayed a great unknown
Like his father banking wood He’d have made good.
Buyouts, mergers, and acquisitions would have suited Jay P best.
He’d have caused nobody harm; no one alarm.

Listen, Jay P, do you care for the growth pace?
Don’t you see we must keep it in place?
We have chip shortages; have you forgotten how hot home sales are?

I am frightened by the Walmart crowd.
For they are getting much too loud.
And they’ll crush us if we go too far.
If prices go too far….

Listen, Jay P, to the warning I give.
Please remember that we want stable prices to live.
But it’s sad to see our chances weakening with every hour.
All your followers are blind.
Too much QE on their minds.
It was beautiful, but now it’s sour.
Yes it’s all gone sour.

P.S.: If you are not familiar with this number, “Heaven on their Minds”, the opening number from the Tim Rice/Andrew Lloyd Webber musical, is a gem.

Doug Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.