Recovery and Inflationary Risk

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Avery Shenfeld

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Avery Shenfeld, chief economist at CIBC.

As the economy picks up, investors are starting to think about whether inflation is in fact a material risk again. One thing that may be setting off some concerns is, particularly for those who watched economies decades ago when this was an important factor, we’re seeing money supply growth in both Canada and the U.S. soar off the charts. So, in the vicinity of 20% or even higher in the U.S. — numbers that, in the U.S. case, really haven’t been seen in data that goes all the way back to Teddy Roosevelt. And in Canada, money supply growth that we haven’t seen since the high inflation era of the seventies and eighties.

There are reasons why all that money supply isn’t driving inflation. Simply put, what it’s capturing is a ballooning in people and people’s and business’s bank accounts. That’s in part a reflection of all the government stimulus checks that have gone out to households and, to some extent, to business owners as well. But that money has been largely sitting idle on deposit. If it’s not out there in the economy being spent and recirculating, then it can’t really drive the demand for goods and services in a way that would create inflation.

The risk though, is that as the economy picks up, particularly in the wake of vaccines, and as we all go out and start spending the way we normally would, could those massive deposits start to create excesses in demand that drive inflation? And the answer is yes, it very much could. That’s why we’re really counting on the Bank of Canada and the Federal Reserve to do the right thing when the time comes.

Now that’s still probably a couple of years away. There’s a lot of slack in the economy, and there’s a lot of capacity to produce more goods and services. Empty hotel rooms, for example; restaurants with half-filled tables or completely empty. So, a lot of ability to respond to demand with more supply, in effect.

But down the road we’re going to need to see a combination of interest rate hikes, and well before that, we’re going to need to see central banks stop buying all those government bonds, in effect allowing longer-term interest rates to drift higher to prevent excesses in borrowing and spending when the economy picks up.

For the Bank of Canada, that’s a message that they’ve been conveying to financial markets. They are talking about raising interest rates come ’23. They’re also, however, engaged a bit earlier than the Federal Reserve in pulling back on their bond purchases. They’ve done it once. And we expect that, over the spring and summer, we’ll see further reductions in the pace of that bond buying to prevent, in effect, an excess of money supply growth driving inflation down the road.

In the U.S., the Federal Reserve is saying we won’t be raising interest rates until 2024, and not really signaling when they’re going to start pulling back on their bond purchases. But our view is that those steps will come earlier than the Federal Reserve is now talking about. Likely rate hikes early in 2023, ahead of the bank of Canada, and a beginning of a pullback in bond buying no later than early 2022.

So, fundamentally, investors are right to be concerned about inflation. We have the makings of an inflation threat a couple of years out if central banks do the wrong thing. But the track record of both the Bank of Canada and the Fed, which now really goes all the way back to 1990 in terms of doing the right thing, preventing a major inflation outbreak, suggests that that’s the most likely outcome here. That we end up with inflation running in the low 2% range, but a gradual upward drift in interest rates. We’re starting with the bond market and longer-term rates followed by actual rate hikes in terms of short-term rates in 2023, and that being designed to prevent the inflation outbreak that might otherwise be harmful to investors.