The inflation episode

Ian Pollick: Pasta. Pasta, like literally, pasta had its biggest ever month over month increase. It was like 14% month over month. These are crazy numbers. Cereals, obviously big numbers. But when you look at the MPR, they had a text box on what the war in Ukraine has done to Canadian CPI.

Ian Pollick: Hello, Mr. Grantham. How are you doing?

Andrew Grantham: I’m doing well, thank you. How are you?

Ian Pollick: I’m doing good, man. I mean, I was away for a couple of weeks on vacation. Much needed. It was awesome. Coming back, a bunch of fresh eyes. Lots of stuff to talk about. So let’s just kick this off. Let’s talk about the Bank of Canada. Obviously, as expected, delivered a 50 basis point hike. The tone of the statement, from what I read, could have been more hawkish. You know, it was hawkish to the degree that they explained what they did. But talk to me a little bit about the forecasts from your perspective. And I also want to talk about the surprising move in the neutral rate.

Andrew Grantham: Yeah. So, you know, relative to our expectations, the statement had to sound quite hawkish, right? You deliver a non-standard increase in interest rates, you’re announcing QT. So, you know, you have to sound pretty confident about the outlook and then pretty hawkish about inflation. A few things stood out for me in terms of the forecasts. What they said in the statement about moving into excess demand and having a very slightly positive output gap, I was a little bit surprised by that. I think they could have, you know, manipulated this short term hit to supply so that they didn’t necessarily have to do that. So that was a little bit of a hawkish surprise in terms of what we were expecting. And then, as you rightly said, the neutral rate, you know, we had pegged that their midpoint would be in kind of the two and a quarter to two and a half percent. So it wasn’t outside of that range, but it was certainly at the top end of that range. So they did move the band for the neutral rate up slightly. So that was kind of interesting. Both those points maybe leaned a little bit more hawkish than we were expecting, but certainly no more than the market was expecting. And you could see that from what was fairly limited reaction at the time. Now, in terms of their outlooks, their forecasts, in terms of GDP, and I know we’ll get on to inflation later because inflation, you know, the latest data was way above what they had even in their forecast just a week ago. But I think what’s very interesting in terms of their growth forecasts is that they are fairly positive for growth this year and next year relative to the consensus. So, you know, even if you don’t believe CIBC’s economics forecast, although you should do, because they’re great obviously. But even if you don’t believe our forecasts, you stack up the Bank of Canada’s forecasts against the Bloomberg Consensus Range for Q2 of this year and for the year as a whole. They are the second highest forecaster and the highest based in Canada. So, you know, they are expecting fairly good growth this year even with the tightening in policy that we’ve already seen. And maybe, you know, again, you don’t just have to judge it based on our forecasts, but based on the consensus, maybe there is some scope for some disappointments later in the year when it comes to those forecasts.

Ian Pollick: Well, one of the things I want to talk about is just when I read the key inputs to the base case and I read the justification for the move higher in the neutral rate, what was interesting is that they largely blamed it on less income inequality in the United States. So they’re basically saying the US job market is very hot. This is kind of consistent with the paper that you wrote that suggested that as US our start goes, so too does Canada. But that seems like a very flimsy excuse to why they raised the band and the stability of lower income inequality, when you’re in a red hot jobs market, that’s very cyclical, that’s not secular. So just talk to me about why they would have chosen that justification.

Andrew Grantham: I agree with you. It does seem to be a little bit of a strange rationale for the move. You know, they have their models in terms of how they determine the US neutral rate and you know, the income inequality part is one part of that and you know they judged that that had improved and kind of the knock on effect of that is that it did raise the boundary for the neutral rate in Canada as well. I think one of the things that we have to remember is that the move that they made up in the neutral rate just offsets the move down that they made at the start of the pandemic, right? When people were worried that the job inequality was going to continue for a long time because, you know, we had very services, low income based decline in terms of employment at first. And, you know, the fact that we’ve had a quicker recovery does kind of justify that. So it does seem strange when you look at it just in terms of the move this time around. But if you compare to where we were pre-pandemic, it doesn’t maybe seem quite as unusual in terms of how they did that.

Ian Pollick: Yeah, no, for sure. I mean, I get that. It was just I read that and it was a very weird justification. And the first thing I thought about is, well, if you move into a late cycle, maybe this isn’t as stable as we thought and it has an equal probability of moving lower as well.

Andrew Grantham: Yeah. And again, you know, it wasn’t outside of our expectations, but it was, you know, towards the top end of our expectations in terms of where that midpoint of the neutral rate lies now. Now, in terms of, you know, we talked about the forecasts and the statement, you know, they did announce QT as well, was going to be starting. What do you think the impact of that is going to be? You know, the speed and, you know, is the market kind of now priced for what’s going to happen in terms of that shrinking of the balance sheet?

Ian Pollick: Yeah, I mean, so we have thought that they would announce it and they did. You know, in the implementation note, there was nothing really in that implementation that caught me by surprise. You know, we had initially believed when we put out a couple of pieces on the topic that the bank would not include primary purchases as part of quantitative tightening. We subsequently changed our tune about a month ago, just because when I was listening to some of the speeches, it became very clear that they were treating all purchases as a stock and therefore they weren’t being cute in terms of the separation. So it seems like it’s largely as expected. It starts on the 25th. It’s a passive program, it’s very transparent and it’s completely passive in nature with no maturity caps. And the thing that, when I think about the risks to this QT program, I would say that I am concerned that because they are no longer buying bonds in the primary market, if you think about the type of system that the Bank of Canada is running right now, which is a subfloor system, and that subfloor is the administered SRO rate, that in a couple of months they’re not going to own any of these building benchmark securities soon to be benchmark securities. And therefore, I think there is a risk here that some of the funding strains that we saw in the two year sector late last year or early this year may reappear themselves because they really don’t have the relevant inventory on a go forward basis. So I don’t think it was entirely a great move. I think it raises the risk over time that they can reintroduce switch operations whereby they take out seasoned bonds and they put investors into new on the runs or building benchmarks. That’s probably the only way they could cure some of this potential scarcity. But I think, you know, the market largely expected it, as you said. And I think we’ve seen the move in asset swaps and swap spreads have moved lower, but that’s also in conjunction with the budget. And I’ll just quickly mention in the budget we got the updated debt management strategy. Issuance is about as we expected. You know, we were the low point on the street, around $200 billion.  Issuance is coming in about $212 billion. But there seemed to have been a shift away from relying exclusively on the long end, and they’ve shifted more towards the front end of the curve. That may alleviate some of the scarcity concerns that I have initially, but I don’t know over time if it’s going to be enough. And I think the fact that we have much higher tier issuance, much higher five year issuance and much lower 30 year issuance is somewhat being mimicked in the shape of the asset swap curve. But that’s very micro. And let’s get back to the macro and let’s talk about the elephant in the room, which is the red hot CPI report. And I’ll tell you, you know, those numbers flashed across my screen and I was like, oh, crap, we’re wrong again. And just for those of you who haven’t seen it, we have changed our call for the Bank of Canada. We do see them raising 50 basis points in the June meeting and I think it was almost exclusively led by the CPI print. So Andrew, let’s just start off with some basics. Why was the print so hot relative to what we had expected?

Andrew Grantham: Well, luckily, we were slightly above the consensus when it was still a good 0.4% in terms of the annual rate higher than we were anticipating. So we can’t pat ourselves on the back too much with that call unfortunately. You get a print like that. Was it one four on the month, six seven on the year? Both of those were what, 0.7 above the consensus or 0.6 above the consensus. You know, that’s not driven by one factor exclusively, right? That has to be fairly broad based. We saw the expected increases in food prices, particularly ones that represented wheat cereals, things that were emanating from the troubles in Ukraine and the disruptions there. Really, the real surprise is, though, some of the core inflation, you know, we continue to see goods prices rise due to strong demand, not necessarily in Canada but in the US. And supply disruptions. Furniture prices were up 8% in just one month. You know, that’s a crazy increase for just one element. And then on top of that, some of the services that are reopening, you know, they started to see a little bit of inflation, hotels and airfares as well. Now, there was one slight change in data source methodology related to housing, which added a little bit to the core print and the headline print. But we’re talking there, you know, 0.1, maybe 0.2 in terms of its contribution to the overall reading, which obviously doesn’t account for the big surprise relative to the consensus forecast.

Ian Pollick: So, you know, one of the things that I was thinking about going back to the MPR, you triggered something when you said wheat prices, cereal prices. And you know, if you dig down into the food price data, you saw that pasta. Pasta, like literally, pasta had its biggest ever month over month increase. It was like 14% month over month. These are crazy numbers. Cereals, obviously big numbers. But when you look at the MPR, they had a text box on what the war in Ukraine has done to Canadian CPI, and they estimate that to date, given everything that’s happened, if it were to completely cease today, it would have already contributed 7/10 to headline inflation. So I think that gives us a good sense of even, if this is a very quickly resolved conflict, let’s say hopefully in the next couple of months, something goes right, that a lot of the damage has already been done to the profile. So the longer this goes, the worse it will get. Or do you think that there’s some convexity here where we’ve seen the most immediate impact right away and therefore it’s diminishing returns afterwards? How did you interpret that?

Andrew Grantham: So the first thing I’ve mentioned is that they said 0.7, but their forecast for Q1 was five six and it turned out to be five eight. They must have been expecting a March print of 6.1, kind of in line with the consensus, right? So, you know, I think when we talk about the impact that the war has had, if they said 0.7, I would suspect, and certainly we’ve moved our forecast up by more than 0.7 since the war broke out, so it’s more like 1%, maybe a bit a bit above 1%. So it’s a complicated question because what we have seen is, yes, we’ve seen these big price increases so far. But you talk about energy, you talk about oil prices, gasoline prices, you talk about food. These are prices that households cannot get away from, right? They have to pay these prices if they want to eat, if they want to drive their car, pretty much, right? So, you know, these are going to have an impact on households disposable income. So all else being equal, in a year from now, if we don’t see further escalation in food prices, we don’t see further escalation in oil prices. You know, we could have a situation where inflation is actually weaker than we would have been expecting because you are having this squeeze on disposable incomes. And, you know, we talk about wage growth. Even in the US, wages have not kept up anywhere close to inflation. And you look at the chart of real disposable incomes, the monthly one in the US, you know, they are now running below the trend that they were running before the pandemic. So this is having a squeeze on people’s incomes and I think it will have an impact on spending, it will have an impact on growth. And that means it probably will have a negative impact on inflation in a year’s time. It’s just judging exactly when that turns is going to be very difficult.

Ian Pollick: Well, let me ask you this. Getting back to the earlier comment you made, they did make that methodology to the home price calculation. Am I right to say that if higher rates start to squeeze home sales and home prices, should the CPI be even more reactive on the downside?

Andrew Grantham: I think it will be, yes. So you know what they have done just to clarify, they have changed the source that they use for home prices, not the one that they use, which goes into their forecast for homeowners replacement costs, right? How much it would take you to rebuild your house? That’s done separately. But there is a house price that goes into their mortgage interest costs and what they call other housing costs, which is now a big component and is basically the fees that you pay for real estate agents when you buy and sell a house. And that change means that they are now using more up to date information. They’re not using a series that’s lagged two months, they use in a series that’s lagged only one month. So in the latest data, that meant that basically two months’ worth of price increases came through in one go. But when you look forward, when you look to the future, it does mean that if house prices do start to come down from their peak because of higher mortgage rates, and I think we must surely see some declines in house prices in the second half of this year. The CPI component will be more reactionary to that because of this change or it will happen slightly earlier. So, yes, I do think that this methodology change, the fact that we could see some kind of slowing in house prices. It’s not just a conversation for the dinner table anymore. It is actually something that has a macro impact because it is a big contribution to growth or this resale activity, but also now to inflation as well.

Ian Pollick: Exactly. So let’s just round out our topic on inflation. There’s two things I want to talk about before we move on to the next topic. The next one is we heard that there is going to be another methodology change where used car prices will now be included in the CPI basket. There’s some people on the street that believe that once you start to include this new CPI component, that inflation is going to go to infinity percent. The gap will close to the US. Talk me through why or why not that’s correct.

Andrew Grantham: I think it’s why not. (laughs) That is not correct. Firstly, there was the speculation that this is going to happen from next month. Now, when you actually read the box and I managed to speak to some people at Stats Can to confirm this, if you read the box, they are releasing a note to detail how they are going to do this next month, but they are not necessarily going to make the change next month because they want to hear feedback from people. So this is not something that we necessarily need to worry about.

Ian Pollick: It’s not a done deal.

Andrew Grantham: It’s not a done deal in terms of how they’re going to do it. Now, in terms of the impact it will have, whenever there’s a methodology change. And we saw this just recently with the house price that we talked about. They can’t backwardly revise the CPI. So we can’t say, okay, used car prices over the last year are up 20%. New car prices are only up 7%. So we’re going to have a level shift up or we’re going to back cast and revise the CPI. That doesn’t happen. That can’t happen. So when we do add this and again, it’s not a done deal, it’s not going to be next month. We don’t know exactly when it’s going to happen, but it will be basically the monthly changes in used car prices tacked on to a starting index of probably 100, whichever month it starts out, whether it’s May or whether it’s June equals to 100. So that’s for the first thing. The second thing is that even if you did include used car prices now, even if you did do all the changes and the revisions, which they won’t do, but even if you did, the impact to Canadian inflation won’t be anywhere near as big as the impact used car prices have had in the US. Firstly, because used car prices haven’t risen as much here as they have in the US. And secondly, you know, we don’t buy as many used cars. That’s not as big a part of our consumption basket as it is in the US. We think about one and a half percent of total consumption is used cars, whereas in the CPI basket in the US it’s about 4%. So yes, we are going to see this methodology change. We don’t know exactly when it’s going to happen, but we have a very good idea that, you know, it won’t be quite as big a swing factor in terms of CPI numbers as it has been in the US recently.

Ian Pollick: And finally we heard that in June they will be doing another update to the weightings in the CPI. And you know, if you remember when we were in 2021, they said, you know what, the CPI weightings are inconsistent with what people are buying. We’re going to revert the weightings to what we saw in 2020, which was largely a containment kind of weighting scheme. So less on gas, more on groceries. Now it looks like we’re almost doing the opposite. So rather than going from we were in a reopening, we’re basing prices off containment. Now we’re basing our reopening on a reopening. And therefore, doesn’t that put some overweight into the parts of the basket that are already pretty hot?

Andrew Grantham: I think overall this change in weights is not going to be anywhere near as big as the change in weights that we saw last year. Because, you know, if you think about it, you think back to 2021, you know, we were still, you know, for the first, let’s say four or five months of the year, we still had some containments in terms of restaurants and that sort of thing. You know, we still had some of those restrictions in place. People were spending more on gasoline because they were driving more. So I think that’s one area that will increase and that’s obviously one area that has been hot. But when you talk about housing, which had the big step up in terms of its contribution in last year’s weighting, I think it will probably stay about the same or maybe come down slightly, but it will still remain very elevated relative to where it was before the pandemic in 2019. I think the big change when it comes to picking up reopening in terms of the weights will actually happen next year when they reweigh for 2022.

Ian Pollick: Okay. Interesting. Interesting.

Andrew Grantham: So now I know we’ve we spend a lot of time talking about inflation. I hope people listening find inflation as interesting as-

Ian Pollick: Are you still there? (laughs)

Andrew Grantham: (laughs) As interesting as we obviously do. But just to touch on inflation, I think this is due to inflation, but I want to get your opinion. We’ve seen, you know, obviously over the last few months, we’ve seen two year rates, five year rates move up quite dramatically as people have reassessed how high interest rates are going. But we’ve now seen a move up in the longer term rates as well. Is this a sign that investors now think inflation is going to be stickier, it’s going to stick around for longer, or is this something to do with QT or do you know what’s driving this increase?

Ian Pollick: It’s interesting. It’s interesting. I think there’s three explanations for it. The first explanation for it is that there’s a lot of money that’s been made successfully on calling the term structure flatter. So a lot of people made a lot of money in their flatteners. And therefore, I think you’re seeing some unwinding of positions. That’s number one. Number two is that with the front end so fully priced and I really mean so fully priced, a lot of this upside that we’re seeing on inflation is pushing the pressure into the back end of the curve, which is a much more traditional response that we would expect in a normal cycle. And, you know, typically all the inflation volatility used to live in the back end of the curve. What we’ve seen over the course of this pandemic, of course, is that the unique nature of the inflation process has really contained all of the inflation premia to your two year sector, your five year sector, and that’s why you have such a deep inversion in your break even curves in North America. So I think part of the second reason is just you’ve had a front end that’s fully priced and therefore the upside to inflation is now being felt in longer term yields. I think the third reason, the one that I think is the least discussed and probably the most important has to do with just quantitative tightening. You know, we heard from Brainard last week that really started to trigger a huge amount of the steepening. It’s this idea that the Fed can run down the balance sheet much quicker than expected. The fact that we are now inverted in many parts of the term structure does raise the probability that a passive program turns into an active program sometime, in let’s say, the next year. And I think the back end is very, very sensitive to that. And it’s interesting because in a market like Canada where we saw the neutral rate moved higher, we’ve now seen the steepening in let’s say our fives tens curve when I would have expected the opposite. So I think that globally we’re getting a spill-over just from this QT trade and unwinding of positions. And I think it’s an interesting dynamic. And, you know, don’t forget, steepeners carry very well right now. You know, that’s a bigger topic. We’re putting a piece out on that. So look for that next week. We are at the 24 minute mark. And if you’re still with us, then I just want to wrap this up by talking really quickly about obviously, you know, I introduced we have a Bank of Canada call change. We do see 50 basis points in the June meeting. Andrew, why aren’t we changing our forecasts for the rest of the year?

Andrew Grantham: We’ve revised it up by 25 basis points, but that’s just the 25 extra that we see in June. What we don’t see is them getting necessarily to the midpoint of that neutral rate yet. And as I said, you know, I think there are reasons out there to suspect that, you know, firstly, growth comes in a little bit softer than they expect. The Bank of Canada is fairly optimistic in its growth forecasts. And also, you know, we talked extensively about inflation, but, you know, once we have seen the peak and hopefully this is it, I think the second half of this year, people will actually be fairly surprised by how quickly inflation comes down because of a lot of the factors that we’ve highlighted. So, yes, we expect 50 basis points in June, but then we expect them to slow down a couple of 25 basis points. But by that time, we should have seen a slowdown in growth below what they are expecting, a slowdown in inflation, not to their target band by any stretch of the imagination, but maybe a bigger slowing than they now expect, which could see them pause at 2% for a little while just to see how the economy progresses. But, you know, we do have to be humble in this in terms of, if we do continue to see these upside surprises to inflation in particular, then, you know, it is possible that they could do more and get to that mid-point of the neutral range even quicker.

Ian Pollick: Oh, don’t worry. We’ll be revising our forecast relatively shortly, I’m sure.

Andrew Grantham: In the next podcast, next weeks’ time. (laughs)

Ian Pollick: (laughs) Stay tuned in the next podcast for another revised bank call. Listen, everyone, we hope you have a great weekend. Thank you for joining. And remember, there are no bonds harmed in the making of this podcast.

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