Douglas Porter

February 18, 2021

As if dealing with the highest inflation in decades was not enough of a challenge, markets were further unsettled this week by conflicting signals on Russia’s intentions with Ukraine. After taking a big step back late last Friday, equities, bond yields and oil prices see-sawed as investors queried “will-they-or-won’t-they-and-when?” A planned meeting next week between Lavrov and Blinken partly calmed conditions on Friday, but uncertainty reigned on the geopolitical front amid Russia’s largest mobilization since WWII. On balance, 10-year Treasuries finished close to unchanged at just above 1.9%, stocks were down for a second week, and oil was holding just above $90.

The intense focus on Eastern Europe temporarily took the spotlight off inflation, and it’s noteworthy that short-term yields actually eased. Two-year Treasuries dipped 3 bps after rocketing 18 bps last week following the blow-out January CPI. The Ukraine tensions have at the very least dimmed talk about a super-sized Fed tightening—late last week, there was even chatter about an inter-meeting hike (and some have called for the Fed to end QE immediately; not an unreasonable ask). While market pricing on Fed rate hikes has dulled somewhat, there are still reasonable odds of a 50 bp move in March, albeit now less than 50-50. We remain comfortable calling for a 25 bp opening hike, followed by two more such steps in ensuing meetings.

The reality is that inflation is now such a heavy-duty risk that the Fed really has little choice but to proceed with hiking, even in the face of potential conflict. A significant flattening of the yield curve, before the tightening cycle has begun, is prompting murmurs about a potential policy mistake by the Fed. After all, the gap between 10-year and 2-year yields has plunged to below 50 bps, down from around 90 bps at the start of the year, and a cycle high above 150 bps late last winter. But while a bit skinny, the narrow 10s/2s spread is not yet in the danger zone for the economic outlook, and that pricing has already built in considerable Fed rate hikes (150 bps this year).

The real ‘policy mistake’ here has already happened: conditions were left too loose for too long. That is not meant to be accusatory, more a statement of fact. Policy interest rates are now deeply negative in real terms almost everywhere, even as jobless rates are nearly all the way back to pre-pandemic levels (which were already very low by historical standards). We monitor 33 central banks closely, and all but four of them currently have their policy rate set below current headline inflation rates. (The four outliers are China, Vietnam, Indonesia and, curiously, Russia.) And the Fed is at the extreme end of the easy spectrum, both across countries and across history, with the groaning gap between 7.5% CPI inflation and a funds rate target of 0-to-0.25%. Again, not to second guess, as no current policymaker had dealt with a global pandemic before, and it was preferable to err on the easy side. But the task at hand now does require some urgency and pace.

That urgency now also applies to the Bank of Canada. After taking a somewhat controversial pass in January, there is now precisely zero doubt that the Bank will hike on March 2. Deputy Governor Lane all but said so in this week’s speech, also noting that QT will be discussed soon. There are some voices here, too, already warning the Bank not to “overdo it” with rate hikes, and the GoC 10s/2s curve is even flatter than Treasuries at 37 bps. But the one-two hit of 5.1% headline inflation and 28% home price gains suggest there is a long way before the Bank will be overdoing anything. We continue to expect a series of four 25-bp hikes to start the cycle, before the Bank briefly pauses to assess the impact.

The broad-based nature of the latest run-up in Canadian inflation reinforces a point we made last week—there is no single factor behind the run-up in prices, and no single factor is going to reverse the tide. There are (at least) six major forces that have brought us here, and we may need to see improvement or relief in almost all of them to temper inflation. Briefly:

• Hyper-stimulative policies, both monetary and fiscal, have juiced demand far above trend. Policy must now be tightened, which will take time to avoid deeply unsettling markets.
• The global shift to spending on goods has focused price pressure and caused some shortages in items that have rarely seen any inflation for years. As restrictions ease globally, spending may slowly revert back to services, although the build-up of savings and pent-up demand will keep pressure on goods spending for some time yet.
• Snarled supply chains and chip shortages have reinforced the price pressures from the demand side. While there are some early signs of reduced delivery delays and shipping rates, many companies are still warning supply will struggle to keep pace with demand through this year.
• The sustained rally in a broad variety of commodity prices, and especially energy, has been a powerful driver of headline inflation globally. With only a muted supply response to $90 oil, the risk is that prices go even further, with the Ukraine tension simply adding to the mix. Food prices also look to remain strong (see this week’s Focus Feature). Given the high profile of both food and energy prices, the risk is that ongoing strength here will unmoor inflation expectations.
• Ongoing health concerns have aggravated worker shortages, with many unable or unwilling to return to work. This issue is most acute for the U.S. economy, where a variety of wage measures have now run above a 5% pace. But given that headline inflation has run far above wages over the past year in many economies, there will inevitably be pressure for catch-up increases in the year ahead, particularly with tight jobless rates.
• Rapid home price inflation is really only now kicking into the official CPI stats. The U.S. owners’ equivalent rent measure has doubled its pace in the past year to just over 4%, but it seems poised to push higher yet amid 19% y/y gains in national home prices. Canadian new home prices are still charging higher, and at 13.7% y/y (house only) are actually a wild understatement of the inferno in the existing sales market.

An added wrinkle to the Canadian inflation outlook is that the loonie is staggeringly stable even in the face of resurgent oil prices. The prior air-tight relationship between crude and the Canadian dollar used to act as an important safety cushion for consumers. Not this time. The loonie is now essentially unchanged since the start of the year, even as oil prices have vaulted almost $20/bbl. As a result, crude prices in C$ terms are now the highest on record aside from the short-lived spike in mid-2008. Combined with wider retail and refining margins and additional taxes (yes, including the carbon tax), this has pushed pump prices to an all-time high in recent days, and up more than 30% y/y. Still, even excluding high-profile pump prices, Canadian inflation sprinted at a 30-year high of 4.3% in January—reinforcing the broad nature of this advance.

Adding it up, it may well be the case that inflation is indeed finally close to peaking, although energy prices will have a big say on the short-term outlook. We are nevertheless expecting U.S. inflation to still be close to 5% by the end of this year, and above 4% in Canada, both uncomfortably above target. The task at hand is for both the Fed and BoC to put on the blinders, shut out the geopolitical noise, look past Omicron news, brave through financial market volatility, ignore the uber-doves, and begin grinding rates higher on a steady and sustained basis. That alone is not going to quell inflation, but it will be a big step in the right direction.

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It is now almost received wisdom that Canada’s fiery housing market is mostly a crisis of supply. We, of course, have long pushed back on this. It’s not that more units aren’t required to keep up with a fast-growing population—no debate there. It’s more a question of what’s really driving this acute situation, and our view is that it’s torrid demand (and specifically investor demand) that’s far out of kilter in this episode. Without rehashing old debates, we will simply point to two facts: 1) the towering price gains have spread far and wide, including almost every small- and medium-sized city in Ontario. From Tillsonburg to Chatham to Barrie, prices have spiked 80% in two years. Do you really believe that each and every one of these centres suddenly has a severe supply shortage, or could another macro factor be at play everywhere?; and, 2) CMHC has just reported that the national apartment vacancy rate was 3.1% in 2021, basically in line with the 30-year average. Question: If Canada has such a severe and widespread “shortage” of housing supply, why then is the rental vacancy rate essentially normal and not almost zero?

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.