Andrew Pyle
September 23, 2022
The inflation problem isn't as clear as some think
On this week’s conference call (playback details can be found here) I made some comments about the battle between central banks and high inflation and how market sentiment has receded on fears this fight ends up throwing economies into recession. Some believe that economic contraction might already be underway in a number of countries and that we have seen peak inflation, suggesting central banks should not keep hammering away at interest rates as they have.
The counter-argument is that while we may have seen the top for headline inflation this past summer, there are components of the consumer price index that continue to advance, which could prevent headline inflation from returning to central bank targets in a reasonable period of time. Without getting overly technical, I thought it would be a good idea to have a look at these culprits of sticky inflation and examine just how much risk there is in preventing a quick exit from the inflation arena.
As the above chart shows, the headline CPI inflation rate in Canada briefly moved above 8% in June but has declined in the last two months to an August rate of 7%. Core inflation, which excludes food and energy prices, hit a high of 6% in July and edged down to 5.7% last month. Because food and energy prices tend to be more volatile, the swings in the core index measure of inflation will tend to be less than the headline rate of inflation. That also implies that some core components can remain sticky longer. Before we look at that, consider the paths that energy and food prices have taken.
Energy prices reached a high in June and with that peak we also saw an annual inflation rate for energy of 35%. While this category of spending will include things like electricity, natural gas and fuel oil, more than half of this group is made up from gasoline and we all know where gasoline prices were towards the end of the second quarter. We also know what happened to pump prices over the summer and the steep slide into August took the energy sub-index back to where it was in March. With this move, energy price inflation fell to 17%. Even if pump prices hold steady into year-end, inflation will drop to about 12% and if they remain flat into May, we will be looking at a negative inflation rate of 12% for energy. These are unrealistic assumptions; however, we haven’t even broached the possibility of further declines in gasoline as demand is crimped – perhaps by a recession.
For Canadian households that are feeling the pinch from rising interest rates, falling gasoline prices is a welcome sight. Unfortunately, there are other budgetary cost pressures that are offsetting this – namely food and shelter. These are big categories as well. In the case of food, expenditures represent north of 16% of the overall CPI basket. Unlike energy, the prices of food continued to move higher through the summer, and, in August, food price inflation hit 9.5%. If we apply the respective weights, food contributed more to the overall increase in consumer prices in August, even though its actual inflation rate was half that of energy.
Shelter costs represent about 30% of the CPI basket, making it the largest of all the major categories. It consists of rent, mortgage costs, insurance, property taxes, utilities and taxes. The upward pressure on mortgage costs is intuitive, given that adjustable-rate and fixed-rate mortgages have all climbed alongside higher bond yields. Not only that, but mortgage values have also increased with rising home prices. You can argue that from a net worth point of view, the higher mortgage outlays are moot, but they still have elevated a major part of the expenditure basket.
Then there is rent. True, there are laws in place that protect existing renters from massive increases, but new tenants are a different matter. Whether we are talking Peterborough or Toronto or Montreal, there is a shortage of rental units available. Landlords, who have been squeezed by marginal allowable rent increases over the years and now increased ownership costs, are more than happy to greet a new tenant with a lease contract that is significantly higher than the previous. Moreover, there is, at the margin, a segment of the population that is dealing with the cold and stark reality of having bought a property at the high, when mortgage rates were low, only to find out that the value of their home is below the balance of their mortgage. Many of them are going to be forced to abandon home ownership in favour of renting. Hence, an increase in the demand for rental units. Add to that the expected rise in immigration after the pandemic lull and you quickly have a recipe for excess demand in the renting space, just like we had in housing.
OK, now that I have gotten you all sufficiently gloomy for this week, let’s take yet another step back and examine what these inflationary forces might do. For one, recognize that all I have talked about so far involves things that we don’t really have a choice in whether we buy or not. We call these things “non-discretionary” items. I can substitute tofu for chicken, chicken for pork and pork for beef, but I have to consume something. I can pay higher mortgage costs on my house or higher rents on my new pad, unless (key point here) I don’t owe on my mortgage, or my parents let me live rent-free in the basement. I also have to put some type of fuel in my car, whether it be gasoline or higher-priced electricity into my EV. And, as I have explained, these items account for more than half of our spending on average. Again, little choice.
The problem is that if we are in an economic slowdown or recession, the ability to cover these higher non-discretionary costs and maintain spending on items we don’t necessarily need starts to diminish. We cut back on new cars, new appliances, travel perhaps and maybe even home renovations. We make do with the swanky new winter jacket we bought last year when there were no discount signs in the store and walk past the “for sale” signs popping up.
Yes, there is still some pent-up demand out there for things we were deprived of during the pandemic, like travel, concerts and restaurants. And maybe we had tons of surplus savings to devote to these things a year ago, but savings are becoming depleted. The pent-up demand wave is, in my opinion, over. This means that overall growth in consumer spending is about to look a lot different and may possibly turn negative in the fourth quarter and/or the first quarter of next year. Since consumption represents about 60% of the economy (more in the US), it is no surprise that economists are ramping up their recession forecasts.
Yet, I said I wouldn’t stay gloomy this week. One thing that a consumption-led slowdown or recession does is take a chunk out of inflation. A brilliant economist that I once worked with used to say, “you can’t fight a recession with an army of unemployed”. Then again, you can fight inflation with that same army and over the coming months and quarters that is exactly what is going to happen. The positive spin is that weaker growth, rising unemployment and declining inflation is what will stop this central bank tightening cycle. If central banks see this development taking place before the end of the year and ease off the brake pedal, then you can still have an economy that doesn’t fall into a 2-4 quarter recession and you can salvage the equity market, alongside the bond market. If not, and interest rates are lifted further into restrictive territory, then a deeper contraction in 2023 will necessitate an even more rapid shift in policy, again favouring bonds.
Have a great weekend everyone
Andrew Pyle
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