Douglas Porter

February 11, 2022

Inflation is a process, not an event. As staggering as the U.S. January CPI reading was—and it was staggering at 7.5% for the headline and 6.0% for core—it’s just one small part of a process that’s been underway for well over a year now. There is no single factor to point to that led us here; but, instead, a series of unfortunate events. Ultra-easy monetary policies, ultra-stimulative fiscal policies, a global shift to buying goods instead of services, workers unable or unwilling to work, supply chain snarls, and profound shifts in the global oil market have all conspired to bring us to where we are today. To come back down the inflation mountain, we may need to see a reversal or some relief on every one of these factors. That is shaping up to be a long process in itself.

In the inflation forecasting Olympics, Team Transitory missed the first gate, fell on the first jump, slipped at the first corner…you get the gist. Now I am far, far too big a person to say “I told you so” on the inflation front. But faithful readers of this space will know that we’ve been in the Larry Summers camp for the past year, warning that inflation was going to run a lot hotter and last a lot longer than the consensus expected. Even we have been somewhat taken aback by just how forceful U.S. inflation trends have turned out to be and have ramped up our estimate on CPI a number of times in the last year. We now expect headline CPI to average more than 6% this year before fading to just below 3% in 2023, both a long, long way from the 1.7% average in the decade prior to the pandemic.

Focusing on the first item on the list of “unfortunate events” above, ultra-easy monetary policies have clearly played a starring role in powering inflation. Recall that the Fed, with great fanfare, announced in the summer of 2020 that its inflation-targeting regime would henceforth change to aim for an average of 2% over the cycle. Having missed that target on the low side for years, the Fed aimed to let the economy run hot for a spell to make up for lost price gains. As we warned, when you run things hot, you risk getting burned, and the Fed has certainly been a major victim of getting much more than it bargained for. And not to let fiscal policy off the hook—the massive stimulus package (American Recovery Plan) of early 2021 was a clear case of overkill for an economy already bouncing back. The combination of super-loose monetary and fiscal policy was essentially a de facto experiment of Modern Monetary Theory. Well, the results are now in—CPI at a 40-year high—and MMT has failed its first test in spectacular fashion.

Financial markets are still coming to grips with the full extent of the challenge ahead of bringing inflation under control. Ten-year Treasury yields have stabilized after pushing above the 2% threshold for the first time since the summer of 2019, on the hot CPI result and increasing talk of a possible 50 bp Fed rate hike in March. The 25/50 debate is just one of many swirling around the pace and timing of coming Fed rate hikes and balance sheet reductions. But perhaps much more important to the longer-term outlook is how much net tightening will the Fed ultimately need to do to bring inflation to heel. Markets remain relatively sanguine on this issue, with the terminal rate priced in just around 2%. For perspective, that’s almost 200 bps north of the current 0-to-0.25% target, a bit above the pre-pandemic level, but still below the 2.25%-to-2.50% peak reached in the prior cycle in late 2018.

In the last cycle, just over 225 bps of net tightening and some moderate QT was more than enough to cool the economy and easily tame inflation. But that followed decades of low and stable inflation, calm wages, unremarkable oil prices, and smooth supply chains. With inflation now at 40-year highs, and possibly poised to test 8%, wages rising at a 5% clip, demand swamping supply in many sectors, and oil above $90, the world has changed. We may all need to start grappling with the reality that the Fed, and other central banks, will need to do more—potentially much more—than the prior cycle.

There are still reasons for optimism that the market has it right, and that only a traditional tightening cycle, taking fed funds back to the old neutral, will be enough to tame inflation. The main points on that side of the debate are:

• 200 bps of relatively rapid rate hikes, combined with QT, will be a powerful tonic, and will also dim financial conditions (i.e., a stronger U.S. dollar, wider corporate spreads, less asset price froth).
• Fiscal stimulus will wane. The U.S. actually recorded a budget surplus in January (the first of the pandemic), and government finances in the past six months are back to pre-pandemic trends.
• Supply chain issues will gradually improve. (However, this week’s extremely unfortunate blockade of the Ambassador Bridge is yet another blow to fragile supply chains, and could at least aggravate some price pressures.)
• A further consumer shift to services spending and away from goods as the pandemic (presumably eventually) fades will relieve some pressure on prices of durables.

However, on the other side, there are lingering concerns that, even with all of those points, inflation will remain sticky:

• Wages are gathering momentum amid tight labour markets and a push to keep up with inflation, suggesting more persistence to inflation—spilling into services.
• Oil and other commodities remain robust, with a variety of supply issues reinforcing a strong demand backdrop. The drought in North America could add another leg to food prices, for example.
• There’s still sting in the tail from hot housing prices.
• Flush household balance sheets suggest demand will remain firm, leaving room for further price increases.

On balance, we do believe that the inflation peak is nearing, and that the moderating forces will help tame it towards 3% by next year. However, that is still well above the pre-pandemic levels. And, that forecast depends crucially on energy prices calming and supply chain issues improving. Needless to say, neither of those assumptions are safe bets, especially in light of recent developments. The risks to the inflation outlook, and thus central bank pricing, remains squarely to the high side of consensus.

Are you ready for some deflation? Amid the non-stop news on rapidly rising prices almost everywhere, it’s gratifying to learn that there’s at least one staple that’s actually getting cheaper. USA Today reports that the price of some Super Bowl tickets has plunged $1000 in the span of 48 hours, a drop of 17%. And that’s despite the game being played in the Rams’ home stadium. Of course, prices are still running above a cool $4400, and that’s for upper deck sections, the highest ever. But, hey, just 1 bitcoin would fetch you nearly 10 tickets. Here’s guessing the Rams will squeak out a victory in a very different game than the defensive dud they lost three years ago. My team (since the days of Roman Gabriel) couldn’t possibly go 1-4 in the big game, could they?

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.