Douglas Porter

September 8, 2023

The inflation beast has not been fully tamed yet, and that reality weighed on financial markets in the first week back from a summer slumber. Bond yields pushed higher again after a bit of late-August relief: 10-year Treasuries tested 4.3% midweek, before relaxing somewhat. Still-high yields weighed on equities, with the S&P 500 slipping after a soggy August. The main source of underlying inflation angst has been a relentless rise in oil, with WTI moving above $87 and Brent driving above $90 for the first time this year. Adding to the witches’ brew, the thin U.S. data calendar this week saw some surprisingly resilient results, including a perky 54.5 on the services ISM, and another dip in jobless claims to a low 216,000.

The steady rise in oil found more oxygen from this week’s surprise announcement that Saudi Arabia and Russia would extend production cuts until the end of 2023. The aggressive measures, notable with oil already hovering near $90, prompted us to boost our WTI price assumptions for the remainder of this year and to $82.50 for 2024. Crude has now jumped more than 25% in two short months and is threatening to throw a serious wrench into the disinflation theme. Suffice it to say, rising oil prices are perhaps the last thing the global economy needs at this point, when inflation expectations were on the cusp of finally receding.

Attention turns to next Wednesday’s crucial U.S. August consumer price report, and energy prices will already feature prominently there too. We reckon that gasoline prices rose roughly 10% in seasonally adjusted terms in the month, which alone will bump up the CPI by four ticks. We look for overall prices to rise a meaty 0.6%, lifting the annual inflation rate to 3.6% (from 3.2%). This impending back-up in headline trends is widely recognized, and the market is likely to take its cue from a much more friendly core result—underlying prices likely only rose 0.2%, clipping the annual rate to 4.3% (from 4.7%). Even so, the bump in headline inflation has real-world consequences for consumer sentiment; buying power; and, perhaps most crucially, inflation expectations. A renewed trip to the 4% zone for headline inflation will also keep the flame flickering on wage demands—witness the dismissal by the UAW of GM’s offer of a 10% raise as “insulting”.

The rumbling of rising oil and higher yields played even louder in Canada this week, amid two big local developments. First, the Bank of Canada’s decision to hold rates steady at 5.0%, after a pair of 25 bp summer hikes, was accompanied by relatively tough talk. Second, the August jobs report mostly landed on the solid side, with employment rising 39,900 and wages staying sticky at nearly 5% y/y. Of course, with torrential population growth, the economy requires a steady monthly flow of nearly 50,000 net new jobs just to keep the unemployment rate from rising—the working age population grew by just over 100,000 last month alone. But the latest gain was just enough to keep the jobless rate steady at 5.5%, and the overall message to the Bank will be one of resiliency.

The combination of a healthy labour market report and a somewhat hawkish BoC pushed up GoC yields by about 12 bps across the curve on the week—including 2s to above 4.65%—a bit more than the comparable rise in Treasuries. While the chances of another rate hike by the BoC are still seen as a bit less than 50-50, no one is fully closing the door on the possibility, and certainly not after the turnabout earlier this year (after the brief spring pause). Governor Macklem’s post-decision speech provided a classic on-the-one-hand ‘we may have done enough’, but on-the-other-hand ‘we may need to do more’.

From a bigger picture, we still lean to the view that the Bank has done enough. It will be a nervous couple of months, as Canada’s headline inflation rate is also about to take a serious trip north on higher energy prices. After falling more than 20% below year-ago levels as recently as June, gasoline is now up 8% y/y, which alone will take top-line inflation to around 4% in the next few months (Chart 1). The next rate decision in late October will thus be staring down a marked back-up in CPI, and the Bank will need to see some signs that core is still ebbing to keep them sidelined.

The domestic growth picture is also likely to keep the Bank at bay. First, it would be a very brave central bank indeed to be even considering hiking rates with the latest quarterly GDP report printing negative. And, even with the solid August jobs report, the underlying story seems to be that the labour market is loosening. To wit, the average jobless rate of the past three months is now nearly 5.5%, compared with last year’s ultimate low of 4.9%, an increase of nearly 0.6 percentage points; the Sahm Rule for Canada says that rise is right on the edge of recession. Moreover, the job vacancy rate is steadily coming down from the highs of early last year (5.7%) to a much calmer level now (4.2%).

The final wrinkle for the BoC is whether the Fed decides to hike one more time this cycle. It’s an even closer call for the Fed, albeit most of the guidance is pointing to a skip for the upcoming September FOMC meeting. The real debate revolves around November, and—full disclosure—while our call is currently for no move, it’s a hair-trigger that could be set off by one sour underlying inflation result.

Of course, the Bank does not necessarily need to instantly react to the Fed’s lead; the two banks were noticeably out of step earlier this year. But the complication for the Bank is that if the Fed does indeed look like it will go again, this will amp up the pressure on the Canadian dollar. The currency has been on its backfoot for the past two months amid a broad rebound in the greenback; even with some firming after the jobs report, it’s close to a six-month low at 73.3 cents ($1.363) and down almost 5% from a year ago. That’s not at all helpful for the domestic inflation outlook, as it aggravates food and energy prices, in particular. Indeed, we have seen the incredibly unusual combination of much stronger energy prices and a much weaker Canadian dollar since early July.

On its own, a lagging loonie would not be enough to pull the Bank back off the sidelines. But, the combination of a further decline in the currency, rising domestic inflation, and a Fed possibly looking to hike again may ultimately be too much pressure for the Bank to bear. Thus, while we and the market cautiously believe the Bank is done raising rates, the persistent strength in oil prices is an unwelcome intruder in that cozy consensus. The bottom line: Not to oversimplify, much, but: higher oil prices = higher interest rates.

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.