Douglas Porter

August 19, 2022

We may be past the high-water mark for inflation, but there is still a long slog ahead in bringing it anywhere close to the comfort zone. That, in a nutshell, is the takeaway from this week’s round of economic data, remarks from central bankers, and market action. Partially in recognition of the hard inflation fight ahead, bond yields generally pushed higher, even with a further moderate pullback in oil prices to around $90. Stocks initially held firm, but eventually succumbed in some late-week softness amid the re-rating in rates. After getting as low as 2.6% at the start of August, the 10-year Treasury yield is now back close to the 3% threshold for the first time in a month. Two-year Treasuries remain stubbornly stuck almost 30 bps higher, keeping the curve inversion alive and well.

Canadian bond yields took an even bigger trip north, rising roughly 20 bps across almost the entire 2s to 10s curve. The biggest move relative to the U.S. was a sharp uptick in the two-year space to 3.45%, nearly 20 bps above like-dated Treasuries after being almost in sync through the first half of the month. Essentially, markets have swung back to the view that the Bank of Canada will ultimately hike rates somewhat further than the Fed—so far, for those keeping score at home, each has boosted overnight rates by a cumulative 225 bps.

The major market driver this week in Canada was the July CPI. The headline result landed right on our call with a modest 0.1% m/m rise, and a half-point clip in the annual rate to 7.6%. But what raised some eyebrows was another uptick in most measures of core inflation. (To completely complicate an already complicated economic environment, there are at least five major measures of core inflation in Canada, and a few more obscure efforts as well.) Governor Macklem noted that half of the items in the CPI basket are now rising by at least a 5% pace (and the “median CPI” is indeed now at 5.0% y/y). That’s the most modest core metric, while the frothiest is at 6%. The so-called common component ratcheted up to 5.5%, apparently exciting the market. However, this former star pupil among core measures has been reduced to dunce status, given huge upward revisions to previously very mild readings earlier this year.

Peak inflation in the U.K. is less a reality than Peaky Blinders, with fuel prices still raging and further hikes on the way—some are now looking at inflation topping out above 13% later this year.

In order to make things somewhat comparable with the rest of the world, we’ll focus on old-school CPI ex food & energy. It nudged up further to a 5.5% y/y pace last month, a full two percentage points above the start of the year. It’s also rapidly catching up with the U.S. pace (now 5.9%, see Chart). Initially, U.S. core inflation was running much hotter than Canada, due to last year’s spike in used car prices and an earlier reopening, which lifted related prices and wages. The gap is now rapidly closing, as the biggest price increases in Canada’s CPI basket are in items such as airfares (+57.7% y/y) and hotel/motel charges (+47.7%). And while some of the steam is starting to come out of sectors that were blown higher during the pandemic by outsized demand and supply woes, there is still lingering pressure. To wit, both furniture (12.5%) and appliances (11.5%) have posted double-digit increases in the past year. While these costs are likely to simmer down as the supply chain improves and housing activity cools, there are plenty of service areas poised to step up; notably, rents rose 4.9% y/y in July. While that’s not as hot as many other items, it’s still the fastest in 30 years and all signs point to plenty more pressure where that came from.

The 5%-to-6% range of core inflation measures in Canada and the U.S. are matched in Australia but are well above the latest 4% reading for the Euro Area and in a different league than the 1.2% in Japan. However, Britain now takes the cake for high inflation in the advanced economies, with core at 6.2% and the headline rate topping double digits in July at 10.1%. Peak inflation in the U.K. is less a reality than Peaky Blinders, with fuel prices still raging and further hikes on the way—some are now looking at inflation topping out above 13% later this year. But Britain may be the exception that proves the rule, as gasoline prices are poised for another sizeable drop in August for North America at least, potentially pointing to a further small step back in overall inflation next month.

The key point is that even if gasoline does provide some further modest relief, and even if food prices relent in the months ahead, we are still facing underlying price trends of around 5% (or more) in much of the industrialized world. Reinforcing that point, a variety of wage measures are now drifting into that zone as well in both the U.S. and Canada. And while the summer rally in financial markets may be gratifying for investors, the strengthening in overall financial conditions will make the job of central bankers that much more challenging. Some have deemed the recent market rally as “self-defeating”, since it could indeed imply that central banks will need to tighten even further—or keep rates restrictive longer—to ultimately rein in core inflation.

A major source of friction between the market and central bank communications has been around the issue of how long rates will need to stay relatively high to corral inflation. We tend to side with the Fed speakers on this issue, and markets are gradually pulling back on the degree of potential rate relief in 2023. With a light data calendar ahead, next week’s headline event may focus on this very issue—Chair Powell’s address at the annual confab at Jackson Hole, Wyoming. This year’s theme for the symposium is “Reassessing Constraints on the Economy and Policy”. Sustained strength in underlying inflation would be a meaningful constraint on both the economy and the room to manoeuvre for policy.

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