The false narrative

Stocks drifted a little lower once again. Rates are rattling everyone. When the cost of money rises, so does the servicing of corporate debt. Meanwhile more expensive loans sap consumers. They buy less. When the economy is two-thirds comprised of people consuming stuff, it’s a tough gig.

Last month hopium abounded as people felt CBs would soon throttle back on their manly towering rates. No more. Big change. The romping employment numbers announced in recent days did that. Then the US inflation report this week. And now the PPI data, which was hotter than expected.

(PPI = producer price index. It measures price changes at the seller level, rather than for consumers and is therefore a harbinger of what’s to come. It was expected to climb 0.4% on the month, and almost doubled that, at 0.8%.)

So, inflation is sticky. Fed member Loretta Mester messed with investors’ heads Thursday when she said: “At this juncture, the incoming data have not changed my view that we will need to bring the fed funds rate above 5% and hold it there for some time to be sufficiently restrictive to ensure that inflation is on a sustainable path back to 2%.”

“This is the new consensus,” says veteran analyst Ed Pennock, noting the bond yields continue to swell.

Bottom line expectation: the Fed hikes again twice (at least) adding two quarter point pops (at a minimum) to hit 5% (or more) and hold it steady (for all of 2023). No pivot, kids. No cut.

Yeah, okay, So what about us confused beavers, huh? Pepe says everything that’s wrong – inflation, grocery prices, mortgage rates and the housing crisis – is the fault of the evil, politicized Bank of Canada. It’s a refrain aped here daily by his steerage section disciples and apostles.

‘Don’t blame Ottawa for rising inflation or rates’

But wait, says a new report from Bay Street economists, this is a false narrative. This mess is a global thing. Canada was just caught in the crosshairs. So jacking up our rates won’t do much more than diddly to get prices back in the bag.

Our view is that most of the inflation we have experienced in Canada results from factors that, to date, have largely been beyond the control of the Bank of Canada. Global supply issues, high (though now lower) commodity prices, transportation bottlenecks and shipping delays, and of course low inventories.

While these factors have the semblance of being supply issues, we take the perspective that the inflation challenge has its roots in the rapid acceleration of global demand resulting from the massive monetary and fiscal stimulus laid out during the early days of the pandemic in 2020. This created a wedge between global demand and supply that was exacerbated by COVID-19 supply challenges.

Here’s the forecast: inflation returns to the 4% level by the end of this year (the CB said 3% by summer). In 2024 we hit the target range of 2%. Interest rates in Canada can probably stay about where they are, despite what the Fed does.

Unless another surprise comes along. If wages escalate and inflation gets worse, the Bank of Canada could increase rates by a further 75 beeps. That would up the chartered bank prime to almost 7.5% and take the stress test to 8%. Ouch. Real estate wipe-out.

But what about a recession? What happens then?

Inflation would drop quickly. “The fall in inflation and economic activity would force the Bank of Canada to cut rates immediately and rapidly.” The bank rate would tumble 1.5% by late 2023 and by the end of 2024 retreat from 4.5% all the way back down to 1.5%. Five-year mortgages would be sub-3%. Variable borrowers would feel like they won the lotto. Of course, in a recession like that the jobless rate would swell rapidly. But coming on top of a 25% national house price decline, a crash in mortgage rates would be enough to rekindle the animal spirits. Real estate soars.

Stuff to mull: US rates are going up and Mr. Market is now absorbing that news. Our guys may follow suit, but slowly. No rate hike likely here until the end of the summer or beyond. Despite what politicos tell you, the suits in Ottawa did not create inflation. And we’ll know in a few months if mortgage rates bloat to 7% or crumble to 3%.

Isn’t this exciting?

About the picture: “Thank-you for your daily blog,” writes Stacey. “You have quite a following in the Comox Valley and we appreciate your advice and wisdom. Here is a picture of our beloved Pepper who passed away at the end of January, 2023. For 15 years she brought joy and happiness to all those who loved her. Perhaps you can use her photo?”