May 14, 2021 | 12:53
That Very Bad 70s Show
Warning: Inflation risks in the rear-view mirror may be closer than they appear.
Every once in a while, an economic statistic comes along that truly changes the prevailing narrative in one fell swoop, suddenly shifting the landscape on the outlook. The U.S. April CPI may just be one of those rare beasts. As staggering as the 4.2% pop in the headline inflation rate was, the true shock was the 0.9% m/m rise in the core, which lifted its annual pace to a tidy 3.0%. To put that monthly jump in perspective, the largest previous rise in the past 30 years was 0.5%. True, outsized spikes in used cars, airfares, and hotel rates alone accounted for more than half of the move; but, even extracting these mammoth gains still leaves us with a meaty rise of more than 0.4% on the core-core. And, commodity prices and wage pressures have only strengthened since April, further fuelling inflation fears, even prompting some talk of stagflation. As if on cue, the long gas lines in the southeast U.S. evoked bad memories of the 1970s, minus only the Buick Skylarks, Ford Pintos and AMC Gremlins.
However, before breaking into a panic at the inflation disco, consider a few mitigating points. And this may sound a bit odd, coming from someone who was just warning two weeks ago about serious upside inflation risks. But besides the well-known base effects in play, the meaty monthly rises were also driven by some clearly temporary factors. Some reflected (presumably) short-lived supply bottlenecks (the 10% spike in used vehicles), and some a catch-up in prices in reopening sectors (a 10% pop in airfares). One way to at least partially control for these factors is to look at the two-year compounded inflation rate; in the past 24 months, both headline and core CPI have risen at a 2.2% annual rate, almost exactly back to the pre-pandemic pace. In other words, prices are mostly returning to “normal”—albeit in double-time.
For this surge to really stick and lead to lasting inflation, there would have to be a shift in expectations and much firmer wage gains. On the former, the University of Michigan’s May survey of consumer sentiment found that inflation expectations have indeed taken a big step up. Consumers believe that inflation for the next five years will be 3.1%, up from 2.7% last month. That’s the highest in more than a decade. Curiously, the implied five-year inflation rate from TIPS is now 2.7%, up from just 2.0% at the start of the year. While an imperfect measure of expectations, it’s notable that the markets and households are largely in sync on which way the inflation winds are blowing. Meanwhile, building wage pressures are quite apparent. So, overall, the main point is that while the April spike in prices is mostly an aberration, it’s the medium-term upside risks for inflation that we regard as much more important.
Financial markets calmed considerably after the initial shock of the outsized CPI print. Bond yields did finish the week slightly higher, but the slim 7-bp rise in 10-year Treasuries overall hardly qualifies as a seismic shift. Still, it is telling that after two big downside surprises on two key economic indicators for April—jobs and retail sales—and the CPI/PPI pop, that yields are higher, not lower versus pre-payrolls levels. While bonds mostly kept their cool, stocks were roiled by the inflation scare, with the highest fliers especially feeling the stress. Even with a late-week recovery, the Nasdaq still peeled off nearly 3%, while the S&P 500 slipped about 2%. The TSX was somewhat supported by its resource tilt, though it slipped roughly 1% from last Friday’s record high.
Curiously, amid the rampant inflation chatter on the week, commodities overall saw little change on net. Gold gained only a touch, admittedly after a nice bounce the prior week. Still, for a legendary inflation hedge, the yellow metal has been mostly a wallflower this year—it began 2021 closer to $1900, since fading on a firmer U.S. dollar. Oil had an early-week run above $66, but retreated back to nearly flat at $65. Even copper, lumber, and iron ore eased a tad from recent lofty heights. But, make no mistake, the momentum in commodities overall remains powerful. To pick but one example, the Bank of Canada’s commodity price index rose another 1.3% this past week and is now up 36% since the start of 2020 (i.e., from pre-pandemic levels).
The flip side of the price spike is the impact on growth from both the cause—the multi-faceted supply disruptions—and the effect. That is, consumer sentiment looks to have been blunted by the price surge, with the U of M’s survey weakening notably in early May, and retail sales flattening last month. Even so, the economy has plenty of underlying momentum rolling into Q2, supported by further re-openings in many states. Note that even with no gain in retail sales, the April level still stands at a massive 25% annualized rate above the Q1 level. As a result, we remain entirely comfortable with our call of 8.5% GDP growth in the current quarter and 6.5% for all of 2021, followed by 4.3% in 2022. It just so happens that both of these annual estimates are now within one tick of the latest consensus calls (6.6% and 4.2%). With the average outlook for 2021 GDP sprinting almost 3 full percentage points since last October, consensus has caught up with our call.
It’s a broadly similar story in Canada, with consensus moving slightly above us in the past month, for the first time in more than a year. With many provinces keeping tight restrictions in place, it’s taking a bigger bite out of growth than the mild second wave dig. On the inflation front, the bite may be milder on Canada’s economy, for two reasons. First, there’s the obvious growth benefit from soaring commodity prices to wide swathes of the Canadian economy. The combined resource sector has seen output surge at a 22.5% annualized rate in the past six months (versus 7.5% for overall GDP). Second, the strong Canadian dollar should blunt the sharpest edges of rising imported prices. In addition, used vehicle prices are not a factor in Canada’s CPI, and airfares are unlikely to match the U.S. spike (with few travelling yet north of the border). As a result, next week’s April CPI is likely to be much less shocking than the U.S. version, even with similar base effects.
Speaking of the 1970s, the NHL playoffs will feature a match-up between the Montreal Canadiens and the Toronto Maple Leafs for the first time since 1979. Looking back to those days of yore, Canada was sporting a headline inflation rate of just over 9% that spring, while the overnight interest rate was just above 10%. Completely different, right? Well, actually, the jobless rate in April 1979 was 8.0% (recall, 8.1% last month) and about to fall quickly, while the Canadian dollar was just above 85 cents(US). So, not so different.
But what was really different was that the Habs were the overwhelming favourite in the 1979 matchup, as the second seed overall (behind NYI). After an upset win over the Atlanta Flames in the preliminary round, the ninth-ranked Leafs were bowled over 4 games to none by the Habs, who went on to win their fourth Cup in a row (beating the Rangers in the finals). This time, the division-winning Leafs are favoured, especially since the Habs were the lowest ranked team to squeak into the playoffs (fewest points among qualifying teams; and, that was also the case in 2020!). And, Montreal had a negative goal differential, one of only two teams to qualify for the playoffs with such a dubious distinction. But we all know that—just like economic data during a pandemic—anything can happen in Round 1.