July 22, 2022 | 14:32
Fingers Crossed at the BoC
You know the inflation situation is troubling when the country collectively sighs at an 8.1% y/y CPI print, because it could have been worse. Still, the 8-handle on headline Canadian inflation is the first since January 1983, and even prompted Bank of Canada Governor Macklem to reassure Canadians that they are on the scene, to defend their credibility and get inflation back to target. Part of the BoC’s pitch now seems designed to establish a narrative that they are being proactive with ‘front-loaded’ rate hikes, for which they cite evidence of softer economic outcomes in the past. But, outsized rate hikes come after inflation had blown to multi-decade highs; after the job market had tightened aggressively to pre-pandemic levels; after excessive froth was allowed to build up in a critical asset like housing; and after inflation expectations had already begun to root into the psychology of consumers and businesses—that sounds more like central bank playing desperately from behind. This is not meant to criticize the BoC (which is hardly alone on this front), but to highlight that this rate-hike cycle is hardly preemptive, and will be very tough for the economy to swallow. Indeed, housing was already in full correction mode even before the 100 bp move, and we currently see real GDP growth fully stalling out around the turn of the year.
The reality is that it’s going to take some luck to ease inflation pressure and save the cycle, so to speak. We’ve seen a bit of it already in the commodity price space, with WTI trading below $95 late in the week, and various base metals and agricultural commodities sharply down from early in the year. When asked if we have hit peak inflation, Mr. Macklem had this to say: “We do expect it’s going to come down when we get the July number a month from now… but inflation is going to remain painfully high for a number of months to come. Monetary policy does work, though. It’s going to take some time to work through the economy, but it does work.” Indeed, at this point the July CPI print looks on track to fall below 8% y/y, but could re-accelerate somewhat later in the year. Encouragingly, momentum in core inflation (either the old-school CPIX or simple ex-food & energy measures) eased in June, but even there the run rate seems to be settling down into the 4%-to-6% range, a level that would take more tightening, or even more luck, to get down to target.
Housing is one very curious aspect of Canadian CPI that actually helped the cause in June, but the overall impact of the shelter component is mixed (and important given that it makes up just under 30% of the CPI basket). There are four major components of shelter that are facing potentially large moves in the very near term: Replacement cost (i.e., home prices), other owned accommodation expenses (i.e., real estate fees), mortgage costs and rent. The first two components (combined weight of 11%) are set to face significant downward pressure, while the latter two (10% weight) are poised to press inflation higher. While that might look like a wash on the surface, in practice, home prices and real estate fees respond much quicker (and in this case, probably more steeply) to changes in underlying market conditions—they could be outright deflationary in the coming months. However, rent is odd in a CPI context because the mechanics cause market changes (which are accelerating now) to enter the official inflation metric very gradually. Mortgage interest costs also lag the reality faced by the incremental buyer, but they are very persistent once they get going—and they are now starting to go. On balance, housing should offer some near-term relief in reported inflation, but it could prove stickier later on.
All told, the Bank of Canada is behind the curve, not in front of it, and needs a dose of luck to bring inflation down without economic consequences.