Douglas Porter

October 22, 2021

It’s looking like inflation is transitory…in much the same way that dinosaurs were transitory — i.e., stomping around for ages, terrifying all manner of beast, and generally dominating proceedings before disappearing. Persistent strength in energy prices, a fast rebound in metals prices, broadening supply shortages —pumpkins and costumes now! — and a new 18-year high in Canadian headline inflation have pushed the transitory narrative further from reality. Certainly bond markets are having serious second thoughts, with 10-year yields hitting 1.70% Thursday in both the U.S. and Canada, the first time since the spring for the former, and since late 2019 for the latter. Yet, equities were far from perturbed by the looming inflation threat, with the S&P 500, Dow and TSX all reaching record highs this week, brushing aside September’s mini correction (which totaled 5.2% for the S&P).

The Canadian dollar is also thriving amid this rising tide of inflation. Just since hitting a nearby low of 78 cents ($1.282/US$) the day of the federal election a month ago, the currency has strengthened by 4% to over 81 cents ($1.235). This entire move is independent of the U.S. dollar, which has actually firmed on a trade-weighted basis over this period. Instead, a broad and powerful rise in commodity prices is leading the way, with mounting expectations of a more hawkish Bank of Canada adding fuel. The BoC’s commodity price index is back on the rise, led mostly by the heavyweight energy component, but also supported by renewed strength in metals and lumber. The overall index is at its highest level since the heady days of 2014 and is up a staggering 60% from pre-pandemic norms.

The downside of that sustained upswing in resource prices, of course, is that this simply adds to the relentless rise in consumer inflation pressures, which now seem to be incoming from all sides. The showpiece economic release of the week domestically was September’s CPI. While the reading really was of little surprise — at 4.4% y/y on the headline, and 2.7% on the average of the three cores — the result seems to have struck a chord beyond the financial world. Landing just as gasoline prices are hitting all-time highs in Canada, the meaty reading reinforced the impression that inflation has arrived. And, the breadth of the CPI rise was impressive, led by strong gains in categories as diverse as cars, homes, meat, gas, and appliances.

In full fairness, some of the eye-popping figures continue to reflect low base effects, and the two-year trend in inflation is much less concerning. To wit, overall prices are up at a 2.4% a.r. in the past 24 months, while excluding food and energy reads 2.0% on the same basis. And, there is even some sign that new home prices, which feed directly into the CPI, are calming a tad, relieving pressure in a particularly big driver. In the past three months, these home prices are up at a 7.7% annual rate, versus the 34-year high for home replacement costs in September’s CPI of 14.4%. Still, make no mistake, the broader short-term trend for overall inflation remains due north, with pump prices poised to rise 5% this month alone and food costs still forging higher.

Even as inflation rages, real activity is mostly disappointing recently. This plays directly into our theme that spending remains strong, but it’s being channeled more into price gains and not volume gains, because supply just can’t keep pace. This week’s slate of other Canadian indicators almost all fell on the soft side of the ledger. True, retail sales saw a nice 2.1% bounce in August, but the flash estimate for September looks for a 1.9% reversal. And, the early read on manufacturing sales also looks for a 3.2% drop, while even housing starts sagged 4.4%, suggesting September GDP may give back some of the nice 0.7% bounce in August (data due next Friday). For Q3 as a whole, even our below-consensus view of 3.5% a.r. growth may be a challenge to reach. (Coincidentally, we are also calling for a matching 3.5% rise in U.S. GDP in next week’s initial reading for the quarter, but we are a tad above consensus on that call.)

Yet, despite the unfavourable mix of higher inflation and mildly disappointing growth, Canada’s equity market is on a roll. At time of writing, the TSX is poised for a 13-day winning streak, and pushing well above the 21,000 level for the first time ever. The TSX is now up almost 22% so far this year; if it can hold those gains, this would mark the best year since the 2009 comeback, and the third best year of the 21^st century. Canada’s big three sectors have little quarrel with inflation — energy and materials naturally fare well when commodities are in favour, while financials are benefitting from a steeper yield curve, and the solid credit gains that are behind the inflation pressure. (The latest household credit data revealed a 7.1% y/y rise in August and a 9.7% pop in mortgage balances.) This is not to say that the TSX is immune to inflation, but it certainly is resilient relative to others. Note that during the great inflation of the 1970s, the TSX managed an annual average rise of 5.9% versus just 1.6% for the S&P 500, and that was before Canada had such a strong energy weighting.

All of these developments turn the klieg lights on the Bank of Canada and its rate decision next Wednesday. In a word, or 30, their current ultra-stimulative policies look far out of step with red-hot housing, record equity markets, decades-high inflation, and employment back at pre-pandemic levels. There are many, many nuances to the announcement, which will also bring the latest quarterly Monetary Policy Report. The three main things to watch for are (among the many keys):

1. Does the Bank push back on the sudden hawkish outlook for policy in the year ahead? The market is now almost fully priced for four rate hikes in 2022, while the Bank has only previously said they won’t be in a position to hike until late that year. We suspect they modestly push back.
2. Does the Bank effectively bring an end to QE, by moving directly to the reinvestment phase? We think yes, as there simply is no justification for such extreme stimulus at this point. QE was unleashed at a time of emergency—there is no emergency now. (Note that Ottawa’s decision to shift away from the wage and income supports of CEWS and CRB align well with a broader unwinding of emergency measures.)
3. Does the Bank significantly adjust their inflation forecast? In July, they expected headline inflation to fade to 3.5% in Q4 of this year, and all the way down to 2.0% by 2022 Q4. Arithmetic tells you the first figure will go higher, and logic suggests the second one is also at risk.

Our projection of an average inflation rate of 3.3% next year (and 2.5% by year end) is based on the assumption of oil prices settling back into a $70-75 range and natural gas closer to $4 in 2022. With WTI currently $10 north of the official call, and natgas hovering above $5, you don’t need an economist to tell you which way the inflation wind is blowing, to paraphrase Bob Dylan.

The Kicker

Even dinosaurs are subject to inflation, apparently (and we are not referring to the salary of the Raptor’s power forward). The bones of a triceratops, affectionately known as “Big John”, fetched almost US$8 million in an auction sale to a private U.S. collector this week. You know the world is awash in liquidity when a bag of bones sells for as much as a luxury home (or two). However, Big John still fell short of a T-Rex skeleton, sold for more than $30 million in an auction last year.

Doug Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.