The Canadian economy continues its robust recovery from the pandemic as evidenced by unemployment declining to 4.9% in June, the lowest level since 1970. Labour shortages across the country continue squeezing wages higher. Canadians are also spending more than ever before, driving up the annual inflation rate to 7.7% in May.
With an overheating economy and rising prices, the Bank of Canada’s (BoC) mission is clear: it must raise interest rates as quickly as possible without triggering a deep recession. That might prove to be a difficult balancing act.
The BoC increased its policy interest rate by 1% to 2.5% on Wednesday, the fourth increase this year. The BoC acknowledged that it must continue to act forcefully to prevent higher inflation expectations from embedding into our collective psychologies.
INFLATION AS A SELF-FULFILLING PROPHECY
While presenting to the Gatineau Chamber of Commerce earlier in June, Deputy Governor of the Bank of Canada Paul Beaudry said: “Preventing high inflation from becoming entrenched is much more desirable than trying to quash it once it has.”
A recent CIBC report sheds some light on how higher inflation expectations could become entrenched. Consumer expectations seem to be driven not by what people buy in aggregate (which is what the headline CPI tracks), but what they buy most frequently. Items such as bread (+11% year-over-year), milk (+8%) and gasoline (+48%) top the most frequently purchased list.
According to CIBC, there is some evidence that consumer inflation expectations can impact their purchasing decisions. For instance, if consumers expect high inflation, they might pull forward consumption at today’s lower prices. This increases demand which in turn increases prices, thereby creating the inflation consumers feared. These price increases feed back into expectations causing a further rise in inflation going forward.
The BoC’s June Survey of Consumer Expectations reveals that 1-year inflation expectations have risen to 6.8% and 2-year expectations to 5.0%. The BoC’s Business Outlook Survey reveals that the distribution of inflation expectations has widened and shifted higher. These are warning signs that a psychological shift could be underway.
Source: Bank of Canada
Another channel in which higher inflation expectations can become embedded is with wages. If firms are convinced that inflation will remain high (and the labour market tight) they may lock themselves into expensive wage hikes to retain and attract a dwindling supply of workers. This in turn forces firms to increase prices to pay the wages they promised.
As Mr. Beaudry acknowledged, once a price-wage inflation feedback loop begins it is difficult to short circuit. Paul Volcker, former Chairman on the U.S. Federal Reserve, broke the feedback loop of the 1970s and 80s by raising the federal funds rate to 20%, causing a major recession. The BoC is trying to engineer a soft landing now (i.e. a mild recession) to avoid a much deeper recession down the road.
PORTFOLIOS DURING PERIODS OF INFLATION
As we wrote here, the high inflation of the early 1970s was just as bad for retiree finances as the Great Depression. The bear market from 1973-1974 ravaged portfolios while prices increased a staggering 23%. Stock losses were much worse during the Great Depression, but deflation caused government bond prices to rise, and spending needs to decline.
Balanced investing benchmarks are down close to 15% this year while spending targets have risen substantially due to inflation. Some investors have a portfolio value large enough relative to spending to be unconcerned about this development. But for others – such as retirees with modest portfolios – the long-term spending level that appeared reasonable six months ago might be in jeopardy now. The best course of action for many retirees might be to reduce consumption until inflation pressures abate and the market recovers. Fortunately, QV clients have experienced smaller loses during 2022 compared to their benchmarks, which should moderate any necessary spending adjustments.