Focus
October 08, 2021 | 13:21
Canadian Inflation Expectation(s)
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Canadian Inflation Expectation(s)Douglas Porter, CFA, Benjamin Reitzes and Shelly Kaushik |
The sustained run-up in energy and food prices is fanning an already smoldering inflation backdrop. As well, evidence is emerging of widespread price increases in goods and services not directly related to supply chain issues or a re-opening bounce. Accordingly, confidence in the transitory narrative is fading, and we remain steadfast in our view that inflation will prove stickier than the consensus and/or policymakers expect. However, just how sticky and how high remains very much an open debate. One important clue to watch on that front will be any significant change in inflation expectations; after a lengthy period of calm, an unmooring of such expectations would signal a more lasting and sustained shift in the inflation outlook. Inflation expectations have been at the heart of a recent debate in financial markets, or at least in the economics corner. A paper by Jeremy Rudd, a Federal Reserve staff economist, provocatively called into question central banks’ belief that expectations play a major role in determining inflation, and—more pointedly—questioned the wisdom of trying to influence these expectations (see appendix). Essentially, his argument can be distilled down to “don’t poke the sleeping inflation beast, especially since we really don’t know how the beast will react.” We sympathize with the view that policies by central banks (specifically, the Fed) to nudge inflation expectations higher risk creating a much bigger problem than the initial issue that policy was attempting to correct. However, we are less on board with the view that inflation expectations are unimportant in projecting inflation. There is a wide body of evidence that expectations play a role, and at the least help improve inflation forecasts. With that as a backdrop, let’s delve into what is actually available in terms of Canadian expectations metrics, and what they are currently telling us—are we in fact seeing a widespread and concerning upswing in inflation expectations in Canada? |
In Canada, existing surveys of inflation expectations are scarce (compared with the wealth of surveys in the U.S.) and largely focus on businesses. For example, the Canadian Federation of Independent Businesses’ (CFIB’s) monthly Business Barometer asks owners of small- and medium-sized firms for their expectations of wages and prices, but only in the year ahead. After a decade of stability between 1%-to-2%, the CFIB survey looks for an average price gain of 3.7% in the coming year (Chart 1). The Conference Board’s quarterly Business Confidence Index asks respondents whether they expect prices to increase within the next six months. And, the Bank of Canada’s quarterly Business Outlook Survey (BOS) focuses on the next twelve months, though the questions include respondents’ views on input cost inflation and output price inflation as well as the headline (Chart 2). Fully 35% of respondents see inflation of 3% or more in the year ahead (as of Q2), the second highest reading in the 20 years of the survey (behind only 2008 Q2) and compared with a normal 5% of respondents calling for such meaty inflation. All of these surveys may provide a view of inflation in the year ahead, but none are helpful in illustrating long-term expectations. Since the Bank of Canada views inflation expectations as a key metric when assessing the outlook for inflation and policy rates, it acted on this lack of reliable or deep survey evidence by creating its own survey in 2014. The BoC’s Canadian Survey of Consumer Expectations (CSCE) is intended to gather insight into consumer views. Unfortunately, its short history makes it difficult to garner any meaningful takeaways. Still, the one-year outlook on inflation (of 3.1%) is at the highest in the seven-year history of the survey (Chart 3). The five-year outlook also happens to be at 3.1%, but that’s actually come down from more lofty readings in earlier surveys. The Bank uses all the survey information available, while also incorporating market-based expectations, to help refine its inflation outlook. Beyond the CSCE, most measures available do not pre-date the adoption of inflation targeting, so it will be challenging for policymakers to assess whether/when expectations are at a turning point. In Canada, market-based inflation expectations are derived from Real Return Bonds (RRBs). The bonds have their par value indexed to inflation, so as prices rise, the value of the bond rises. RRBs are only issued as 30-year bonds, with the first issue coming in 1991. Indeed, the first RRB maturity will be taking place later this year. Inflation expectations (or breakevens) are calculated from the difference between nominal bond yields and RRBs’ real yield. While markets are commonly thought of as “efficient”, the RRB market doesn’t always provide an accurate picture as it can be an illiquid product at times. Earlier BoC studies noted that while the levels of breakevens can be misleading, the direction of movement does provide a signal with respect to where inflation expectations are headed. Canada 30-year breakevens have pushed higher in recent weeks, but at around 1.75%, remain tucked under the BoC’s 2% target and miles away from the latest inflation print of 4.1% (Chart 4). Moreover, the current implied long-term inflation rate, while well up from around 1.3% in the months immediately before the pandemic, remains very close to the median reading over the past 10 years of just above 1.7%. The main point here is that there is no sign of a significant breakout in long-run inflation expectations at all—a firming, yes, but not a break. In contrast, U.S. 10-year breakeven inflation rates from the TIPS market have pushed above 2.5%, a half-point above the average reading of just under 2% in the past decade. |
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Finally, some short- and longer-term inflation expectations can be directly pulled from surveys of professional forecasters (which include us). There is a long history of projections for one or two years out, and they have almost invariably gravitated around the 2% level (or less) in the past decade. For example, through much of last year and even at the start of 2021, the consensus expected CPI inflation to average just under 2% this year (Chart 5)—but that call has steadily moved higher to around 3% now (we’re at 3.1%). Even with that big miss, the consensus still looks for inflation to fade to an average of 2.5% in 2022 (we’re 3.0%), easing to just 2.0% by the second half of the year. Essentially, the official consensus view among forecasters is fully buying into the transitory narrative. Survey evidence on longer-term projections is a bit more sporadic, but the consensus has generally been locked into a 2% view for a prolonged period of time, and that conviction has not yet broken. The main reasoning for that view has been: a) the Bank of Canada’s target has been set at 2.0% for more than 25 years, and b) actual headline CPI inflation has averaged 1.9% in that period. It’s tough to challenge that long-term track record. |
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On balance, the evidence from surveys, forecasters, and bond markets points to a notable pick-up in the one-year outlook on inflation, but no significant shift in longer term expectations—yet. This fits well with the broader narrative that the current bump in inflation will eventually prove to be transitory. However, the steady upswing in a variety of longer-term U.S. expectations metrics, the increased public focus on inflation in recent months, and the sustained strength in energy prices all suggest that Canadian expectations may also shift in a more meaningful way. Bottom Line: Measures of Canadian inflation expectations are not particularly robust, but can still contribute to signaling a significant shift in the inflation outlook. In the past year, we have seen a dramatic swing in near-term expectations from very sedate levels at the start of 2021 to match some of the steamiest readings on record. Still, most of these measures have yet to break away from historical ranges, and have been pumped up by one-off or unique factors. The test for how long this inflation episode persists is whether these expectations fade as some of this year’s special factors relent or even reverse. Our core view is that underlying pressures will persist for longer and louder than the consensus expects, and expectations will reflect this reality. The Debate: Do Expectations Matter?Mainstream economics generally takes for granted the theory that inflation expectations are a key driver of actual inflation. Instead, Jeremy Rudd argues in a recent paper [1] that businesses raise their prices only when their costs materialize to a point that their customers are fully aware of those pressures, rather than when those businesses owners expect those costs to appear. Similarly, workers expect their wages to keep up with observed increases in the cost of living and will quit if that is not the case (this is more apparent now that large portions of the labour market are not unionized). His point is that if workers do quit, it’s because their wages are lagging actual changes in the cost of living, and not because they are lagging anticipated future changes. Based on historic data, Rudd claims that there is a threshold under which inflation is so low that it does not enter workers’ employment decisions—in the mid-1960s, that was about 3%, with increases felt broadly across most categories. More recently, since the mid-1990s, trend inflation has been stable in the U.S. around 2% despite changes in economic conditions and in inflation expectations. The pressing question now is whether the high inflation readings in recent months are transitory, or whether the pandemic has shifted the previously stable long-run trend. So, if inflation expectations can’t guide us, what’s the alternative? Instead of expectations, Rudd argues that long-term inflation trends can be predicted by wage dynamics. To gauge whether inflation trends have shifted, he suggests looking out for indications that rising prices are starting to pressure wages. Are quit rates starting to mirror price changes? Are wages for new hires (which are generally more flexible) rising more than wages for existing employees? The answers to these questions can help determine whether inflation is high enough to enter wage decisions; and, therefore, high enough to shift its own long-run trend. Ultimately, the paper argues that policymakers should not focus on inflation expectations at all; instead, the goal should be to keep actual inflation low enough such that it does not affect people’s everyday decisions. Not only should policymakers not focus on expectations, Rudd argues that, in fact, it would be dangerous to add it into decision making at all, since it can’t be measured directly. In short: “given the huge boon to stabilization policy that results from a stable long-run inflation trend, actions that might jeopardize that stability would appear to face an unusually high cost-benefit hurdle”. In Canada, a divergence between headline inflation and consumers’ perceptions of inflation has been well documented—with consumers believing inflation is much higher than suggested by official statistics. Given that disconnect, it would not be a stretch to suggest that expectations of inflation are not well anchored to trends in headline inflation. Unfortunately, Rudd’s suggested alternatives are not readily available in Canada given a lack of data. For example, StatCan’s measure of “job leavers” (which remains near record lows) counts all people who quit their job in the past year. And, measures of wages do not distinguish between new hires and existing employees. We do have surveys that indicate business owners foresee a need to raise wages to attract more workers, but relying on those surveys re-introduces the risk of focusing on indicators that are difficult to measure. Footnote:[1] Jeremy Rudd, “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)”. Federal Reserve, Staff working paper, September 23, 2021, https://doi.org/10.17016/FEDS.2021.062. [^] |