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Economic Commentary

June 17, 2022
Inflation Reality Bites
Douglas Porter, CFA, Chief Economist,,
You know we have a serious global inflation episode on our hands when even Switzerland is surprising markets with an aggressive 50 bp hike. The normally staid SNB felt compelled to crank rates this week for the first time since 2007 as headline CPI approached 3% following ten years of precisely zero inflation in that nation. That momentous decision was somewhat overshadowed by the Fed’s mega 75 bp rate hike—a move that would have been shocking about 8 days ago, but had become conventional wisdom in the immediate lead-up to the FOMC meeting. Chair Powell somewhat softened the blow by suggesting that such hikes would not become the norm, but then in the same breath allowed that the next move would be 50 bps or 75 bps (we pick door #2). The first market response to the Fed action was to rally, but serious second thoughts about the task ahead led to additional pain for all risk assets.

Arguably, this past week saw markets, investors, central banks, and forecasters finally cast off any remaining denial on the inflation front. The watershed moment was likely last Friday’s U.S. data—which Powell very specifically cited in the press conference, in an amazing bout of clarity. We are often fond of saying that no single economic release will sway a central bank, but it appears that two may do the job. In this case, it was the outsized May CPI, and inflation expectations from the University of Michigan’s consumer sentiment survey. With headline inflation rising (to 8.6%) instead of falling, and five-year expectations heading up to 3.3% (a full percentage point above pre-pandemic trends), the Fed felt the need for immediate speed. In the ensuing days, Powell abruptly discarded prior forward guidance in favour of Wall Street Journal guidance.

Markets took on the news of even higher highs for short-term rates with all the enthusiasm and vigour of an exhausted runner asked to run a second marathon in the Arizona desert. In the five sessions after the CPI release (i.e., up to Thursday’s close), the S&P 500 promptly shed 8.7%, descending into ‘official’ bear market territory. Treasuries went on an absolutely wild ride—many maturities took a peek at 3.5%, before relenting—with 2s rising a net 31 bps over the five days. And, after a relative period of calm, credit spreads gapped higher through the week. Essentially, with the dawning realization of how much work still lies ahead for the Fed, markets began to price in the rising risk of an economic hard landing.

A wide variety of pundits greeted the Fed’s move, but especially their latest economic projections, with something approaching scorn—the word “fantasyland” was apparently trending in the aftermath of the FOMC. The common refrain now is that the Fed is going to need to lift rates much higher than the dot plot suggests, and the economic damage will be much more serious than the moderate slowdown Fed officials are now projecting. Readers of this space will be well aware that we have been pounding the drum on the upside risks for inflation since early 2021, and we remain doggedly at the high end of consensus expectations for CPI in both the U.S. and Canada. However, where we differ from this emerging chorus of Fed doubters is on how high rates will need to go to seriously chill the economy (and thus, eventually, inflation). Our view is that growth will prove to be highly sensitive to the combination of coming rate hikes, the drag from inflation, QT, less fiscal largesse, and—in the case of the U.S. at least—a strong dollar.

We now expect the Fed to hike rates to the 3.25%-to-3.50% range by year-end (a 25 bp lift from previously), and then stay there. Recall that just barely three months ago, the funds target was still 0-to-0.25%; this call would imply 325 bps of tightening in nine months. The Fed has not hiked rates at such a rapid pace since, well, the early 1980s. (The great tightening cycle of 1994/95, which this episode seems most closely related to, saw a total move of 300 bps in 12 months.) A 325 bp rise will make a major dent in growth—we look for GDP to essentially stall late this year and into early 2023. In fact, there are early signs that growth is already catching a chill from high inflation, and even rising rates. A big pullback in housing starts last month may be a first warning that near-6% mortgage rates will take a fast toll. The Atlanta Fed’s GDP Nowcast is already looking for no growth in Q2, after an actual 1.5% dip in Q1.

The next issue is how sensitive inflation will be to a significant growth slowdown, and this may well be the nub of the debate. In other words, will it take a full-blown downturn to bring inflation under control? Many have noted that it has always taken a recession to cool inflation from current trends to anywhere close to the Fed’s target. Being charitable, we’ll focus on the PCE core deflator (the mildest measure, but also the target instrument). It’s now running at a 4.9% y/y clip, and the Fed would likely be content if it could even recede to below 3%. And, yes, it has taken an economic downturn every time in the past 50 years to bring this measure down by that much in a year or so. However, as in so many other ways, this cycle truly is different, and there is the possibility that inflation may prove more sensitive to a cooling economy this time.

Here are a few reasons to believe that inflation pressures could relent sooner than a normal cycle:
  1. Calmer demand for goods could help alleviate supply chain issues and perhaps even the chip shortage. Recall that we have had the very unusual situation where durable goods prices rose 22% in the past two years after declining over the prior 25 years.
  2. The super-heated labour market could turn quickly, cooling 6% wage growth. A modest back-up in jobless claims and a calming of hiring intentions may be the first signs that the balance is shifting.
  3. Probably the biggest wildcard is commodity prices, and especially energy costs. While obviously erratic, even a mild slowing in global growth could tilt the ultra-tight oil market into better balance. While it’s just one week, the pullback in crude prices in recent days is a taste of what could come in a meaningful slowdown in global growth.
Having said all that, we’ll make a nod to our bias of the past two years—that inflation will not recede without a serious fight. But at the very least, markets have now fully taken that view on board, and are well aware of the challenge ahead.

Canada is poised to receive (yet another) loud message of the coming intense inflation fight. The May CPI on Wednesday threatens to be potentially even more shocking than the U.S. version a week ago. We expect a 12% pop in gasoline prices to drive a monthly move of above 1%, lifting headline inflation to 7.4% (from 6.8%)—and the risks seem skewed to the upside on that call. In the event, we suspect that this will be enough to convince the Bank of Canada to also unleash a “highly unusual” 75 bp rate hike next month. Like the Fed, we have also bumped up our call on the end point for BoC rates by a quarter to 3.25%, bringing the cumulative expected tightening to 300 bps. Historically, that’s not really out of bounds in a Canadian context—but history had never seen household debt above 180% of disposable income before the past few years.