Douglas Porter

May 13, 2022

The road ahead is long and treacherous, replete with plenty of potential deep disappointments, the occasional rush of relief, but unquestionably fraught with serious danger and possibly ending in devastating heartache. And, no we are not talking about the Maple Leafs’ playoff outlook—it’s bringing inflation back to home base.

This week brought a harsh reminder that there are simply no easy wins in this environment for inflation. Even with the generous helping hand of lower used car prices and a temporary lull in gasoline prices, U.S. CPI still landed on the high side of expectations in April and remained stubbornly above 8% on the headline and north of 6% on core. Germany confirmed its 7.8% pace for the same month, the highest that nation has seen since 1973. Even China reported a faster-than-expected 2.1% clip, despite a lockdown hit to growth.

Compounding the sticky April readings, energy prices are displaying some real resilience, with WTI rebounding to US$110 by Friday, and natural gas holding near $8. And, product prices are flaring even more vigorously—notably diesel—amid a refinery squeeze and falling Russian exports. Grain prices are also weighing in; after a brief respite, wheat prices climbed again with some longer-dated contracts hitting fresh record highs on a dire outlook for this year’s global crop. Note that U.S. grocery prices were already up 10.8% y/y last month.

The mounting unease about the inflation challenge ahead undercut markets broadly. Prior to a late-week bounce, the S&P 500 had been approaching unofficial bear territory, while the TSX completed a quick 10% correction from its late-March peak. Upstart crypto markets even got into the act, with so-called stablecoins proving to be anything but, while Bitcoin acted like a high-beta meme stock. As one wag suggested, cryptocurrencies have proved to be mostly a hedge against getting rich in 2022.

Notably, bonds actually moved in the opposite direction of risk assets this week—a big change from most of this tough year. In a bullish flattening move, 10-year Treasury yields fell more than 20 bps to well below 3%, while 2s dipped by roughly 10 bps (albeit keeping the 2s10s spread at around 30 bps). The moderately good news here for investors is that we may have passed maximum bearishness for Treasuries, dependent on how inflation unfolds in the months ahead, of course. We suspect that U.S. inflation is likely to slowly grind lower over the next year—assuming no further spike in oil prices—but with the emphasis on “slow”. To be clear, we remain well above the consensus on the inflation outlook: we are expecting headline inflation to average 7.8% this year and 4.0% next, while consensus is now 7.2% and 3.3%.

Attention will turn to Canada’s April CPI report in the coming week. Unlike the U.S. figures, Canada did not have the used car spike a year ago, so the base effects are less friendly. In that vein, we believe that the apex for headline inflation still lies ahead, expected to push above 7% through the spring. That threshold may not be breached next week (we are calling for a 6.8% rate), but it now seems like only a matter of time. Suffice it to say that this is already far above the Bank of Canada’s latest forecast (released less than one month ago). Deputy Governor Gravelle “humbly” allowed in a speech this week that their projections were going to rise again—the MPR had an average inflation rate of 5.8% in Q2 (we believe it will be above 7%) and 4.5% by Q4 (we think 6.5%). As in the U.S., we are loud and proud in our top-of-consensus forecasts for inflation this year and next. Indeed, the bigger concern is that even we are still underestimating the tenacity of inflation.

Faithful readers of this space, yes both of you, will be well aware that we are no shrinking violets when it comes to holding the Bank of Canada’s feet to the fire on policy decisions and communications. This is always in the spirit of trying to foster even better decision-making in Ottawa, by adding some Bay Street perspective, and offering some pointed comments when necessary. So, it’s a little unnatural for us to defend the Bank (which can do a perfectly good job on its own on that front), but here goes…

• Even with the outsized 6.7% current headline reading on CPI, note that the 10-, 20-, 25-, and 30-year annualized trends in headline inflation are now 2.0%, 2.1%, 2.0% and 1.9% (respectively). Looking over many cycles, and through lots and lots of drama, inflation has essentially been right on the Bank’s target for the three decades of inflation targeting.
• From Ghana, to Greece, to Germany, inflation is flaring almost everywhere. Clearly, much of the rapid rise is well beyond the control of domestic policymakers. One way to look at it: Goods prices, which are mostly driven by global factors, are up a towering 9.2% y/y, while services prices, which are mostly driven by home-grown factors, are up 4.3%. The latter is too hot for comfort, and requires rate hikes, but it’s not a four-alarm fire.
• Forecasting mistakes were made by almost everyone and every institution, in an incredibly challenging backdrop over the past two years. Yes, we explicitly warned about an inflation earthquake a year ago, and have long been inflationistas, but even we have been surprised by the ferocity of prices. As for policy decisions, note that as recently as December, the C.D. Howe’s Monetary Policy Council (a body of academic and private sector economists) called for only modest rate hikes in 2022—the median recommendation at that time was for a 0.75% overnight rate by June; the Bank will instead likely have it at double that by next month. In fact, the BoC is out-hawking the biggest hawk on the independent council.
• Finally, we will just note that the current BoC Governor assumed his current role on June 3, 2020. At that time, the Bank’s balance sheet had already expanded to $478 billion. As of the latest week, it stood at $471 billion of assets. In other words, the QE water had already been flowing strongly under the bridge long before Governor Macklem made any policy decisions. And, among major central banks, the BoC was arguably the first off the mark to start reining in QE, and warning of the need to tighten.

We recognize that these remarks can be seen as a highly predictable response from an “elite seat”, and/or possibly from someone defending their turf on BoC critiques from an interloper. But we also don’t want to be witness to a messy modern-day version of the 1961 Coyne affair—the one time a BoC governor left office amid a policy dispute—especially not at such a critical juncture for the economy.

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.