Douglas Porter

November 12, 2021

After an initial stumble, markets responded reasonably well to the latest shocking U.S. consumer price reading, which famously saw inflation jump to 6.2% y/y in October. Aside from a brief spell in late 1990, when oil prices soared in the lead-up to the first Gulf War, inflation has not explored the 6% zone since 1982. We have been relative inflationistas since the early spring—persistently warning of upside risks—but even we have been consistently surprised by the ferocity of inflation this year. And the upswing is certainly not confined to the U.S., as Germany posted its highest inflation rate (4.5%) since 1993, and Canada is primed to report its fastest result since 1991 (we estimate 4.7%) on Wednesday.

Even so, markets are now seemingly inured to ever higher highs for CPI, apparently still on board with the Fed’s loosely defined transitory narrative. Treasury yields pushed higher in a broad flattening move—the biggest rise was a 20 bp bump for 3-years—but the overall curve doesn’t look wildly different than just prior to last week’s Fed tapering announcement. Some cooling in energy prices and a further marked pullback in freight rates (Baltic Dry) calmed the waters somewhat. Stocks blinked hard at the meaty CPI, but the S&P 500 was headed for less than a 1% pullback from Monday’s record close.

With headline CPI gripping the 6-handle, inflation has clearly gripped the public imagination in a way not seen in decades. Inflation concerns are likely behind the deep drop in consumer sentiment, with the University of Michigan index falling to 66.8 in November, even lower than the depths of the early pandemic in 2020. One-year inflation expectations have pushed up to almost 5% in the survey. To look for historical guideposts for what lies ahead, it is now quite fashionable to harken back to the unfashionable 1970s, the era of the last great inflation. In that decade, U.S. headline inflation averaged 7.4% (and 7.5% in Canada), a full 5 percentage points higher than the prior decade’s norm. That sorry episode did not reach its crescendo until inflation peaked at nearly 15% in early 1980 (and, painfully, not until mid-1981 in Canada, albeit at a ‘tamer’ apex just below 13%). Piling on, unemployment rates often visited double-digit terrain in those tough years, in what was a true example of stagflation.

However, the focus may be on the wrong decade for a historical lesson of past inflation episodes. Everyone wants to talk about the 1970s, and its Rocky Horror Inflation Show, but the 1950s may in fact be the better comparison. So, when considering the inflation outlook, think Elvis, not Elton. Think Marilyn M, not Farrah F. Think Ike, not Jimmy Carter. Think Rocket Richard, not Guy Lafleur. Think Grease, not Godspell. Think West Side Story, not Saturday Night Fever. You get the picture.

First let’s take a brief recap of the history of the 1950s inflation experience. (Full disclosure, I have precisely zero first-hand experience with the 1950s, but was well acquainted with the 1970s!) The peak inflation rate of the past 100 years was actually hit in both the U.S. and Canada in the immediate aftermath of WWII. The U.S. high was 19.7% in March 1947, but that truly was an extreme situation as the consumer economy absolutely boomed after the war, and prices made up for a decade of deflation in the 1930s. That spike faded quickly, and inflation was actually negative again within two years. A little more germane was what followed in the very early 1950s. As the attached chart suggests, inflation made a comeback soon after, pushing above 9% in early 1951, as the Korean War began to boil. (It zoomed to above 13% in Canada later that year, a pace it has not since surpassed in the ensuing 70 years.)

Importantly for the current situation, inflation then faded rather abruptly from the various post-war spikes. After approaching double digits in 1951, U.S. headline inflation receded to zero by 1953, went negative in 1954, and averaged -0.3% in 1955—the last time inflation would average less than zero for a full year until 2009. Inflation would see a mild upward ripple late in the decade but would then stabilize and remain cool and calm around 2% until late in the 1960s.

While there may not be a precise parallel with current conditions, the sharp sawtooth pattern of inflation during the instability of the post-war era—a time of rebuilding, and financial repression—may be a better comparison than the sustained and long-lasting strength of the 1970s. True, there are some echoes of the 1970s in current conditions—a sudden surge in energy prices, a rapid run in food prices amid a bad global crop, robust social spending, a severe job market mismatch, ABBA—but there are also a lot of key differences. Demographic forces have shifted from spurring inflation then to acting as a dampener now, union power is a shadow of the 1970s, and the weight of food & energy in the CPI basket is down by a third from the early 1970s.

The main point is that we are not pre-destined to follow the pattern of any prior episode, because each has its own unique underpinnings. And, where we go next also depends on the policy response (among other factors, such as, say, the weather this winter). While we are quite concerned that the current run of inflation has yet to see its apex in North America and remain quite comfortable being firmly on the high side of consensus for 2022, even we look for some moderation by the back half of next year. The U.S. CPI is now expected to post an average increase of 4.7% next year (latest Blue Chip consensus is 3.8%, albeit perhaps not fully taking on board the most recent jump), before receding to around 2.5% in 2023. This calming is based on three key assumptions:

1. The Fed will begin to respond with a bit more urgency, and hike rates starting shortly after mid-2022.
2. There will be a more complete rotation in spending towards services and away from goods, relieving the global tidal wave of demand for ‘stuff’ in the past year. In turn, this should dampen commodity prices broadly: we are assuming oil prices to average $70-to-$75 in 2022.
3. Supply pressures ease and/or adjust, relieving some of the most acute shortages, helping tame cost pressures.

A final word on the appropriate policy response to this inflation spike. Many analysts have asserted something along the lines of “monetary policy can’t do anything to improve supply chain issues”. That may be true, but there are two blades to the inflation scissors we are caught in—supply and demand. And policy can certainly be honed to dull the demand blade, which arguably is even more extreme due to the hyper-stimulative policies of the past two years.

Now that we have the staggering U.S. CPI in hand, all eyes in domestic markets will be trained on Wednesday’s October reading for Canada’s prices. The local CPI results have been consistently a little lower on the shock scale this year, with the monthly seasonally adjusted gains yet to top 0.6%. However, this one may come closer to the U.S. jolt. We are expecting a hefty 0.7% m/m rise, sparked by a 5% pop in gasoline, food prices still rising rapidly, and auto prices adding to the mix. Large portions of the country more fully reopened in the month, potentially pumping some previously held-back prices. Housing may act as a small temporary damper as new home price gains actually cooled in the latest month (up 0.5%, compared with an average rise of 1.0% in the past year).

Our resulting 4.7% call for the annual inflation rate would mark the fastest pace since 1991, the year the GST was introduced (which alone added more than 2 ppts to headline CPI). Given this year’s extensive history of high-side inflation surprises, there’s little doubt on where the risks are for our call.

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.