Brighter forecasts bring inflation, rate hike worries

Amid strong economic data, progress on vaccine rollouts and further fiscal stimulus, economists are raising their forecasts for recovery and accelerating expectations for higher inflation and interest rates.

In a new report, National Bank Financial Inc. (NBF) indicated that it will soon upgrade its baseline forecast for the U.S. economy and revise its rate outlook.

“To us, it now appears likely that the U.S. output gap will be closed by the end of 2021 — an astonishing feat given just how ugly things were a year ago and highlighting once more how fundamentally different this latest recession has been from all those that have gone before it,” the report said.

RBC Economics echoed the view that the U.S. economy could return to full capacity this year. RBC also sees Canada growing faster than expected, returning to full capacity in the first half of next year.

Economists expect both the U.S. Federal Reserve Board and the Bank of Canada to upgrade their growth forecasts in the months ahead.

Rosier economic prospects have financial markets on guard for signs of inflation and tighter monetary policy. Indeed, evolving expectations have already prompted a sell-off in government bonds, RBC noted.

Economists indicated that there are signs of inflation appearing in the goods side of the economy. The vaccine rollout is raising expectations for a reopening of the service side of the economy, coupled with the unleashing of pent-up consumer demand.

In the U.S., there’s more fiscal stimulus on the way as another US$1.9 trillion is pumped into households with US$1.5 trillion in excess savings already in hand. This will boost consumer demand even further, RBC said.

Yet, it remains to be seen if the inflation pressure is temporary or something more durable.

For now, economists expect central banks to shrug off initial signs of inflation — at least until it’s clear that the recovery is fully entrenched.

Another factor that will likely keep central banks patient is the unequal impact of the pandemic, with women and racial minorities suffering greater job losses than others.

“Central banks are emphasizing this labor market divide more than ever as a contributor to the muted link between the job gains and inflation,” said a report from TD Economics. “As a result, central banks may choose to test the lower limits of the unemployment rate in this cycle.”

Indeed, economists noted that central banks won’t want to risk moving too early, only to have to backtrack later.

“Nonetheless, we think some central banks will hike rates sooner than markets are anticipating,” RBC said. “Beyond a temporary, near-term jump in headline inflation, we expect a return to full capacity in the U.S. and Canadian economies will help sustain near- or even above-target inflation in 2022.”

As a result, RBC said, both the Fed and the Bank of Canada are likely to raise rates modestly next year.

NBF said that it sees rate hikes from the Feb by early 2023, after the Fed winds down its quantitative easing (QE) program.

“Assuming the Fed takes 12-18 months to wrap up QE, and starts the process as early as this fall, the earliest the overnight rate could be nudged higher looks to be in/around [the first quarter of 2023],” NBF said. “That’s when we’ve formally penciled in the first of what could be three hikes in 2023.”

TD has the Bank of Canada starting to raise rates “at the end of 2023 and eventually reaching 1.75% in 2026.”

“In the meantime, the improved economic outlook will continue to be incrementally priced into financial markets. This will edge bond yields higher and keep reinforcing the curve steepening dynamic,” TD said.