Bank of Canada Governor Tiff Macklem takes part in an event at the Bank of Canada in Ottawa on Oct. 7.BLAIR GABLE/Reuters
Inflation is running at its hottest pace in three decades. So is the rhetoric around it.
According to Twitter chief executive Jack Dorsey, “hyperinflation” looms over the global economy. The U.S. Federal Reserve and other central banks are risking “an otherwise-avoidable recession” if they don’t leap into action and start tightening policy, warns Mohammed El-Erian, the international money manager who now serves as president of Queens’ College, Cambridge.
Yet financial markets remain mostly unperturbed. Stock prices shrugged off news this week that U.S. inflation hit an annualized pace of 6.2 per cent in October, the highest rate since 1990. Bond yields inched upward in response, but remained historically low – not the reaction one would expect if an inflationary apocalypse were bearing down upon us.
For investors, the conflicting signals add up to a baffling muddle. So what to do? A good place to start is by examining both sides of the inflation debate.
The inflation-is-nigh crowd insists that central bankers in the United States, Europe and Canada are profoundly wrong in characterizing the current wave of price increases as “transitory.” This amounts to “one of the worst inflation calls in decades,” Mr. El-Erian wrote in the Financial Times this week.
He and others see growing evidence that inflationary pressures are broadening. Among the dire portents are surging producer prices in China. The prices received by producers in that country jumped 13.5 per cent year-over-year in October, the fastest pace in 26 years. If factory-gate prices in Asia are any omen, consumers in North America should brace for more price increases ahead.
Those who are convinced a surge of inflation is advancing toward us cannot understand why central banks are refusing to act despite the flashing red lights on the economic dashboard. Policy makers have learned over the past few decades to hike their key interest rates when prices are rising. The goal is to put a lid on inflation by making it prohibitively expensive to borrow.
But that is not happening this time around. In fact, if you subtract the inflation rate from the central bank rate to arrive at the real cost of borrowing from the central bank, many countries now seem to be doubling down on their easy money policies.
In Canada, for instance, the Bank of Canada’s 0.25 per cent policy interest rate is way below the total consumer price inflation reading of 4.4 per cent. The result is a deeply negative real policy rate. Rather ominously, the last time real policy rates sunk this low was the mid-1970s – not exactly a golden age for inflation-fighters.
Given that ugly precedent, it is easy to see why so many people are so worried. But there is another side to this story that also deserves to be aired.
It hinges on the belief that the pandemic has propelled us into unprecedented territory. Never before have countries deliberately shut down huge swaths of their economies while simultaneously showering money on workers and companies.
By and large, the pandemic relief has worked as planned. Businesses and households are emerging on the other side of the emergency in decent condition. But one side effect of combining lavish stimulus with widespread lockdowns has been to distort normal buying patterns beyond recognition, especially when it come to the relative mix of goods and services.
Consumers slashed their spending on services when the pandemic struck, because many service businesses – gyms, restaurants, hair salons, hotels – closed their doors or reduced their offerings. People compensated by splurging on durable goods – exercise bikes, sofas and that new e-scooter you just had to have. Practically overnight, spending on durable goods in Canada and the U.S. shot up more than 20 per cent from its prepandemic levels.
It is no great surprise, says Team Transitory, that the sudden lust for goods has overwhelmed supply chains and ports. But those strains – and the accompanying price pressures – should ease in the months ahead.
If so, the worst thing to do right now would be to aggressively hike interest rates at the same time as governments are cutting back on pandemic relief. Higher rates would risk hammering an economy that is just beginning to fumble its way back to normalcy. What’s more, higher borrowing costs would do nothing to directly untangle supply chains, clear crowded ports or lower oil prices.
So who is right in this debate? Both sides make good points, but the recent data have not been kind to Team Transitory – at least, not if you define “transitory” to mean inflation will fade quickly, of its own accord.
Expectations for future inflation have climbed in recent weeks to uncomfortable levels. Breakeven rates (which reflect the difference in yields between conventional bonds and inflation-protected ones) suggest that U.S. consumer price inflation could run at an average of more than 3 per cent over the next five years, well above the Fed’s 2-per-cent target. No, Mr. Dorsey, this is nowhere near hyperinflation. Nonetheless, it is disturbing.
What may be restraining an even more violent market reaction is the conviction that the Fed and the Bank of Canada are not prepared to sacrifice the decades of hard work they have put in building their reputations as inflation fighters. If inflation continues to ripple higher over the next few months, they will nearly certainly act – maybe not as dramatically as some would like, but enough to signal they mean business.
Investors, who have benefited greatly from rock-bottom interest rates over the past couple of years, should not count on that happy state continuing.
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