November 18, 2022 | 12:36
World Cup Runneth Over With Inflation
World Cup Runneth Over with Inflation
The latest North American CPI results were slightly better than feared, with U.S. headline inflation receding to 7.7% and holding steady at 6.9% in Canada. While both were lower than our expectations, we are sticking to the view that consensus is underestimating the persistence of underlying inflation, and remain about one percentage point above the average consensus call for 2023 inflation (Chart 1). Make no mistake, headline inflation is expected to moderate significantly over the next year, with receding oil prices, an improved supply chain, and slower spending all contributing. We simply are not as convinced that the pullback will be as dramatic as is commonly believed at this point, and will continue to warn about upside risks to the inflation outlook.
The recent modest improvement in North America is a bit of an outlier globally, where inflation readings continue to forge higher. For example, last month saw headline CPI drive above 11% in Britain and just shy of that marker in the Euro Area—with at least five of those economies north of 11% (Chart 2). Among major economies, the U.S. inflation rate is now roughly middle of the pack, while Canada’s is near the lower end. Only the traditionally low-inflation economies of Switzerland and Japan, as well as the special case of China, are now meaningfully below Canada on the inflation sweepstakes.
Drilling more deeply into Canada’s latest results, it was all the usual suspects driving the still-lofty headline. The fastest growing components of the basket (on the right-hand side of Table 1) can be clumped into five broad themes: (1) the reopening bounce (airfares, hotel charges), (2) the energy price surge, (3) supply chain pressures (furniture, appliances), (4) the global food crisis, and (5) the pandemic housing boom. That’s five different things that need to stop going wrong to help wrestle inflation back down. The good news is that some of these drivers are indeed stalling, and even reversing in some cases. Energy prices have calmed and oil is now close to year-ago levels. The deepening correction in housing is capping shelter costs. Supply chains are improving, while lower shipping costs and rising retail inventories are blunting the price of many goods.
Ebbing inflation in some prices for goods—especially consumer durables and gasoline—is the good news. The bad news is that services are now becoming the key inflation driver, especially in the U.S. (Chart 3). And, services account for just a little more than 50% of the CPI basket in Canada, and more than 60% of the U.S. basket. Food and energy prices clearly remain the primary wildcard in terms of the overall inflation outlook; but, provided that neither delivers another big shock in 2023, central banks will focus mostly on core trends.
While services have clearly taken over as the main concern stateside, it’s a bit more subtle in Canada (Chart 3 again), where used vehicle costs have not been the same source of drama. But, as Chart 4 suggests, there has historically been about a one-year delay between a big shift in goods prices and then for services, at least for Canada. This drives home the point that just because the price of some goods may be moderating, it is far too early to send the all-clear signal.
While U.S. underlying inflation looks like it is now cresting, it is starting at a high altitude at above 6%, at least for the CPI. The Fed’s preferred measure, the core PCE deflator, was running much cooler at just above 5% in the latest figures (September). In fact, the gap between core CPI and the core PCE deflator in that month was a whopping 1.5 percentage points (6.6% vs. 5.1%), the widest in more than 30 years. Suffice it to say, this big difference complicates the narrative around how far inflation is from target. Indeed, by the PCE measure, the U.S. is arguably as close (or even closer) to its inflation target than is the case in Canada, where the two main measures of core are now averaging just over 5%.
More broadly, the previously wide inflation gap between the U.S. and Canada is now receding quickly, albeit not yet back to pre-pandemic levels (Chart 5). The 6% drop in the Canadian dollar in the past year has boosted food, energy, and some other imported goods. And, the used car impact spiked U.S. inflation last year, but is now dragging on it, narrowing the inflation gap abruptly. With inflation differentials between the U.S. and Canada narrowing, this raises the question of whether there’s such a clear-cut case for more tightening moves by the Fed versus the Bank of Canada. Markets currently have priced the U.S. terminal rate about 50 bps higher than for Canada, not far from the current gap in headline inflation.
A more complete breakdown of the major components reveals that a wide variety of categories now have very similar inflation trends in the two economies (Table 2). For example, big-ticket items like new vehicles and furniture & appliances are running at a similar pace, while gasoline, alcohol and tuition fee increases are roughly matching, and even medical services and owner-occupied housing costs are nearly identical despite completely different conceptual treatments. The main reasons for Canada’s lower inflation rate can be attributed to different weights on some key components, as well as much lower reported inflation trends in electricity, air fares, auto insurance, and telephone services. Aside from the big asterisk on used vehicle prices, the only component where Canadian inflation is significantly higher than stateside is for hotel & motel charges, which mostly reflects the later re-opening in Canadian tourism.
In summary, North American inflation led the global pack on the way up, and may now be at the forefront on the way back down. Given that the Fed and the BoC have been among the most aggressive tighteners this year, and that Europe’s energy price dynamics are less favourable, the path to lower inflation looks more straightforward for the U.S. and Canada. However, straightforward does not equate to easy. The major source of inflation pressure has shifted from goods prices to services prices. And, services inflation will prove tougher to wring out of the system. So while October’s inflation results were a wee bit better than expected, we remain entirely comfortable at the high end of consensus on the North American inflation outlook for 2023.