Any new suggestions, Maestro?

Cast your mind back a couple of decades, if you will, to a time when Alan Greenspan was Chairman of the US Federal Reserve. It often seemed as if the main goal of Fed policy was to support the stock market -- the so-called "Greenspan put" -- rather than to focus on preserving the purchasing power of the dollar by keeping inflation low. To justify this, Greenspan scrolled through a variety of increasingly obscure price indices in order to justify his view that the traditional measures were overstating inflationary pressures.  

So, out went the fuddy-duddy, old style CPI, to be replaced first by the snazzy employment cost index (ECI).  When  that no longer served, Greenspan pivoted to the rather arcane personal consumption expenditure deflator, particularly the "core" version that excludes food and energy prices.  These indices, compiled by the Bureau of Economic Analysis at the Department of Commerce, have apparently remained favourites of the Fed ever since.

It's no surprise to learn that these indices are now flashing the same danger signals as the more widely-understood CPI. Data released by the BEA today show that the overall PCE deflator rose 6.4 percent in the year to February. The rise was led by a 25 percent rise in energy prices and an 8 percent gain for food, both of which are of course excluded from the "core" version that Greenspan particularly favoured. Even without those components, however, the core index rose 5.4 percent year-on-year. 

Current Fed Governor Jerome Powell is very evidently not cut from the same cloth as the Maestro. Today's data, coupled with the hawkish tone of recent rhetoric from the Fed, are intensifying expectations that the FOMC will raise the funds target by a full 50 basis points at each of its next two meetings.  Recall that one dissenting member of the Committee favoured such a move earlier this month; that is highly likely to be the consensus position come early May.

Briefly switching north of the border, a more aggressive Fed would make it easier for the Bank of Canada also to pursue a faster pace of tightening. The data flow continues to support that. Today StatsCan reported that real GDP rose 0.2 percent in January, despite the presence of relatively stringent COVID restrictions across the country. StatsCan further estimates that as those restrictions were lifted in February, growth accelerated to 0.8 percent, and anecdotal evidence points to continuing strength in March. 

Both the Fed and the Bank of Canada know that the current causes of inflation cannot easily be treated by monetary measures. Their key short-term goal is to keep inflation expectations in check, and that certainly points to the need for a "statement move" of 50 basis points from each at the earliest opportunity. Beyond that, all is data-dependent.

Dropping a heavy hint

There's a bit of a tradition emerging at the Bank of Canada for the Governor to allow one of his senior deputies to make important policy statements. This started when Stephen Poloz was in the top job and Carolyn Wilkins was Senior Deputy Governor. In part the logic may be to showcase the deputy as a possible future Governor, though of course that did not work out for Ms Wilkins. But it may also be designed to give a kind of plausible deniability to the Governor: it may be less embarrassing to walk back a seemingly unambiguous policy statement if it is delivered by a deputy rather than by the boss himself.

This brings us to a speech last week by Deputy Governor Sharon Kozicki, delivered virtually to a conference in San Francisco, that has been widely interpreted as signalling a more rapid tightening of monetary policy.  Much of the speech dealt with Canadian household finances, but at the conclusion of her remarks Ms Kozicki addressed the policy outlook directly.  Some highlights:

With slack in the economy absorbed, we raised our policy rate to 0.5% in early March and said we expect it will need to rise further. We also said that we will be considering when to begin to allow the Bank’s holdings of Government of Canada bonds to shrink—a process known as quantitative tightening, or QT.

We were clear that the timing and pace of further increases in the policy rate, and the start of QT, will be guided by the Bank’s ongoing assessment of the economy and its commitment to achieving the 2% inflation target.

I expect the pace and magnitude of interest rate increases and the start of QT to be active parts of our deliberations at our next decision in April. The reasons are straightforward: inflation in Canada is too high, labour markets are tight and there is considerable momentum in demand......

The invasion of Ukraine is adding to inflationary pressures around the world and in Canada. This is primarily because it has caused global prices for oil and other commodities to surge. The result is inflation in the near term that is expected to be higher than we projected in January, when we published our latest projections. A key concern for us is the broadening of price pressures—around two-thirds of the components in the consumer price index are now exhibiting inflation above 3%. Persistently elevated inflation increases the risk that longer-run inflation expectations could drift upward.

..... it’s important to be clear that returning inflation to the 2% target is our primary focus and unwavering commitment. We have taken action and will continue to do so to return inflation to target, and we are prepared to act forcefully.

In the wake of these remarks, and particularly that final "forcefully", markets have been aggressively reassessing the outlook for rate hikes. A hike of 50 basis points is now almost the consensus expectation for the next rate setting meeting (April 13), with a cumulative rise of 225 basis points now expected by year end. bringing the rate target to 2.75 percent. 

This reassessment may have gone too far.  The Bank will want to be cautious about outpacing the Fed in the tightening cycle.  Rising global energy prices have pushed the Canadian dollar up by about two cents against the big dollar since the start of the year, and excessively rapid tightening would exacerbate that trend, harming the competitiveness of the non-oil sectors of the economy.  The Bank may well choose to send a strong signal with a 50 basis point hike in April, but after that, in this year of all years, expect its decisions to be highly data-dependent. 

One small step for the Fed

As expected, the US Federal Reserve has launched its tightening cycle, raising the funds target rate by 25 basis points to 0.25-0.50 percent. Interestingly, one Governor, James Bullard, dissented from with the decision, preferring a full 50 basis point rate hike. 

Under Jerome Powell's Chairmanship, FOMC statements have become fairly lengthy, but today's is a model of concision, at just four paragraphs. This obviously reflects the extreme uncertainty that has been created by the Russian invasion of Ukraine. A brief opening paragraph recites the well-founded basis for tightening -- job gains, falling unemployment and rising inflation -- but then quickly moves on to the Ukraine invasion. In the Fed's view this is "likely to create additional upward pressure on inflation and weigh on economic activity."

The rest of the statement is pure boilerplate, with a brief reference to plans to start reducing the Fed's balance sheet "at a coming meeting". The key sentence is this:  "With appropriate firming in the stance of monetary policy, the Committee expects inflation to return to its 2 percent objective and the labor market to remain strong."

That is an admirable statement of confidence, but is it misplaced?  It is hard to see how, in current circumstances, the Fed can use the monetary tools at its disposal to bring inflation all the way down from its current level, let alone the double-digit numbers that may well be seen in the next month or two, without severely crimping growth and the jobs market.  The Fed was facing a tough balancing act this year even without Vlad the Invader's depredations in Ukraine; the job isn't getting any easier, but at least the Fed has finally made a start. 

The records keep tumbling

Markets were, to use a favourite media term, braced for a bad number when Canada's February CPI data were released this morning. The actual outcome was even worse than expected: the year-on-year rise in headline CPI came in at 5.7 percent, up from 5.1 percent in January and easily topping the consensus expectation for a 5.5 percent rise. That's the biggest gain for any month since August 1991, when CPI rose 6.0 percent -- a figure that may well be surpassed soon. 

The details of the report reveal more unwanted records. Unsurprisingly, gasoline prices were a major contributor to the overall increase, rising 6.9 percent month-to-month and 32 percent from a year ago. Excluding gasoline, the rise in CPI for February was 4.7 percent, easily the highest reading since StatsCan began compiling this series in 1999. As that number implies, price pressures in the month were broad-based. Shelter costs rose 6.6 percent from a year ago, the fastest annual rate since 1983. Food prices rose 7.4 percent, a number that is merely the highest pace for this component since 2009 -- scant consolation!

The Bank of Canada's preferred measures of core inflation are also continuing their inexorable march higher. The average of the three measures rose to just shy of 3.5 percent in February from 3.3 percent in January. The worst-behaved of these slightly arcane measures, "CPI-trim", has now reached 4.5 percent. 

The near-term outlook is somewhat difficult to discern. A week ago, it looked like a safe bet that soaring gasoline prices would push headline CPI yet higher in March. However, the somewhat unexpected fall in world crude prices has quickly translated into lower prices at the pumps. Much will depend on exactly when StatsCan's survey data are recorded.  

Beyond that, however, there are good reasons to think that headline CPI will not go back below 5 percent any time soon.  The sheer breadth of the current inflation surge is one reason; another is the strong likelihood that global food prices will be pushed higher as the year progresses, even if the Russia-Ukraine conflict ends relatively soon. Lastly, the recent resurgence of the COVID pandemic in China may well portend further disruptions to global supply chains. 

Taking all of this together, it looks quite obvious that the Bank of Canada will keep raising rates by 25 basis points at every Governing Council meeting this year.  There are still analysts on Bay Street who expect seven such hikes by year-end. Things may not turn out to be that simple. The fact that such major components of everyday spending as shelter, food and gasoline are leading CPI higher means that consumer demand may very quickly get squeezed -- recall that average earnings are up only 3.1 percent from a year ago. 

Whisper it not, but that talk of multiple rate hikes is being heard at the same time as the dreaded term "stagflation" is once again being bruited about. The Bank, like its opposite numbers from DC to Frankfurt to London, will have to keep its wits about it. 

The big bounce

Canada's employment data for February, released by Statistics Canada this morning, are simply remarkable. The economy added 337,000 jobs in the month, double the market expectation, more than reversing the 200,000 decline in employment reported for January. This brought the unemployment rate down by a full percentage point to 5.5 percent. Not only is this lower than the pre-pandemic rate of 5.7 percent -- it's within a tick of the all-time low of 5.4 percent posted in May 2019.

Are the details of the report as strong as the headline?  For the most part, they are. For example:

• the private sector more than fully accounted for the overall increase, adding 347,000 jobs in the month;
• particularly strong gains were seen in sectors that had been hard-hit by omicron-related restrictions at the turn of the year, with accommodation and food services employment up 114,000 and information, culture and recreation up 73,000;
• full-time employment rose 122,000 in the month, with the 215,000 rise in part-time employment reflecting the rebound in the sectors most affected by COVID restrictions; 
• job gains were seen in eight of ten Provinces, with Alberta and New Brunswick the only exceptions; 
• total hours worked rose 3.6 percent in the month and are now 1.7 percent above their previous all-time high, set in February 2020; 
• work-from-home, long-term unemployment and labour force underutilization all fell in the month. 

One indicator that is still lagging is wage growth. While the year-on-year growth in average hourly earnings rose to 3.1 percent in February from 2.4 percent in January, it remains far short of the rate of CPI inflation. Still, the evident tightness in the jobs market that today's report reflects will ben seen by the Bank of Canada as a further reason to continue gradually tightening its policy settings. 

The wild card now and for the foreseeable future is the Russian invasion of Ukraine. The February data were collected before that happened; the survey week for the March employment report starts this coming Sunday (the 13th).  There is little circumstantial evidence to suggest that the Ukraine situation is yet having any impact on economic activity and employment in Canada,  and COVID restrictions continue to ease, so another robust outcome seems likely.

It's only going to get worse

Another month, another multi-decade high for US consumer price inflation. The BLS reported this morning that headline CPI rose a higher-than-expected 7.9 percent in the year to February, the largest increase since January 1982. The month-on-month increase was 0.8 percent, up from 0.6 percent in January. 

Perhaps the most ominous thing about today's data is that the survey on which the numbers are based was taken before the Russian invasion of Ukraine began on February 24.  This means that the surge in gasoline prices, which now takes up almost as much of the nightly news bulletin as the invasion itself does, is not captured in the February data.  This points to another increase in the annual rate in March, with the early consensus looking for something in the range of 8.5 percent.

There are few surprises in the details of the report. Even without the full Russia-Ukraine effect, gasoline prices were up 38 percent from a year ago, accounting for fully one third of the overall increase in prices.  Food prices are also rising, led by the food-at-home subcomponent, which rose 1.4 percent in the month to stand 8.4 percent higher than a year ago, the biggest such increase since April 1981. Excluding food and energy, the annual increase in the index is 6.4 percent, better than the headline number but not much consolation for the Fed when its target inflation rate is 2 percent. 

There are now at least a few voices out there calling for the Fed to hold off on interest rate hikes until the uncertainty created by the Russian invasion starts to clear. Although the pace of tightening is likely to be slower than seemed likely until a couple of weeks ago, a rate hike at next week's FOMC meeting is both inevitable and warranted. The Fed can be under no illusion that rate hikes can quickly bring the running level of inflation under control. However, it clearly needs to send a signal of its intent, in order to stop inflation expectations from getting out of hand. It would be unfair to suggest that Jerome Powell and his colleagues should have seen the invasion coming, but it's definitely fair to say that they would look much better today if they had started the tightening cycle back in January.

Powell at the plate

Fed Chair Jerome Powell was unusually explicit in his semi-annual Humphrey-Hawkins testimony to the House Committee on Financial Services this week, saying "With inflation well above 2% and a strong labor market, we expect it will be appropriate to raise the target range for the federal funds rate at our meeting later this month." The FOMC is scheduled to meet on March 15-16.

It's probably safe to assume that Powell had seen the February non-farm payrolls report before making that statement. The BLS reported this morning that the US economy added 678,000 jobs in February, far in excess of the markets' expectation of a 400,000 gain. While this pushed the unemployment rate down to a post-pandemic low of 3,8 percent, aggregate employment in the US remains more than 2 million below its pre-pandemic peak, as the effects of the so-called "Great Resignation" persist. 

With inflation at the consumer level already above 7 percent, it may be some consolation for the Fed -- though not for the average American worker -- that average hourly earnings scarcely budged in February.  The year-on-year increase of 5.1 percent means that average living standards are eroding even as the economy bounces back. 

The relatively sluggish rise in wages is evidence that the current surge in inflation is not comparable to past inflationary episodes. It is driven primarily by supply chain problems, which implies that any Fed move to raise rates will be aimed primarily at keeping inflation expectations in check, rather than directly attacking the underlying causes of inflation in the short term.

The big wild card for the Fed is, of course, the Russian invasion of Ukraine. This has already pushed gasoline prices, always a hot-button issue in the US, to levels not seen since 2005. The surge in that year was the result of Hurricane Katrina, which could reliably be expected to have only a transitory impact, as indeed it did. There is no such reassurance now, and thus Powell's continued confidence that inflation will start to head lower this year might be said to be based more on hope than expectation -- or econometrics.  Inflation at more than three times the target rate calls for multiple rate hikes in short order. A hot war in Europe, not so much.

One small step

As expected, the Bank of Canada today raised its overnight rate target by 25 basis points to 0.5%, the first rate increase since 2018. It signaled that more rate hikes are coming, despite growing uncertainty over the outlook, but for the time being is holding off on reducing the size of its balance sheet. 

The case for rate hikes was clear by the start of this year and recent economic data have only served to underline it. Economic growth in Q4/2021 was well above the Bank's expectations at 6.7 percent (annualized rate), which "confirms its view that economic slack has been absorbed".  The Bank believes that the impact of the omicron COVID variant is already fading, so that "first-quarter growth is now looking more solid than previously projected".

As for inflation, the January reading of 5.1 percent is of course far above the Bank's target range: "Price increases have become more pervasive, and measures of core inflation have all risen". Monetary policy may have little effect on the current causes of inflation, but the Bank's concern is to ensure that inflation expectations do not drift away from the 2 percent target. Therefore "The Bank will use its monetary policy tools to return inflation to the 2 % target and keep inflation expectations well-anchored". 

Viewed in a vacuum, this language and the recent data would clearly signal the Bank's intention to raise rates several more times during 2022 , and until a week ago this was the consensus expectations among Bank-watchers. The Russian invasion of Ukraine is a huge complicating factor. Gasoline prices at the retail level are set to reach all-time highs by this weekend in response to the soaring cost of crude, and the impact of the war will inevitably spill over into other commodities, as the Bank's press release makes clear.

The growth impact of the events in Ukraine is more complicated from a policy standpoint. The press release notes that "negative impacts on confidence and new supply disruptions could weigh on global growth". In the aggregate this is certainly true, but as Canada is a net energy exporter, the impact is likely to vary widely across the country. The oil patch in Alberta and Saskatchewan was already booming before the Ukraine crisis boosted energy prices yet further, while energy importing Provinces such as Ontario could take a significant hit. This will create a tricky balancing act for the Bank:  2022 shapes up as one of those years where a "one size fits all" monetary policy is way less than ideal. 

The stage is set

Not that there was much doubt anyway, but the strong Canadian GDP data released by Statistics Canada today make it certain that the Bank of Canada will start a tightening cycle on Wednesday, raising its rate target by 25 basis points. It would normally be safe to assume that this would be the first of several moves this year, but the extreme uncertainty over the geopolitical situation makes it hard to be sure how quickly the Bank will be able to act.

Real GDP rose 1.6 percent in the final quarter of 2021, up from 1.3 percent in the prior quarter. This brought growth for the year as a whole to 4.5 percent, following on from the 5.2 percent decline posted in 2020 -- a decline which, it should be recalled, was entirely concentrated in the first half of the year.  In some respects the Q4 data were a little weaker than the headline suggests: final domestic demand rose only 0.7 percent, less than half the rate posted in Q3. Real growth was driven by the rather obscure category of home ownership transfer costs, as well as a rise in business inventories that historical trends suggest is unlikely to persist for very long. 

StatsCan also reported real GDP data for the month of December. This showed GDP basically unchanged from the previous month, which is a surprisingly strong reading given the hasty reimposition of COVID restrictions as the omicron wave ramped up. As these restrictions remained in place through January, it is equally surprising that StatsCan's preliminary estimate for that month sees GDP growth of 0.2 percent. This points to a robust growth pace for Q1 as a whole, given the removal of many of the COVID restrictions in February and early March. 

It remains to be seen whether rate hikes can bring inflation back towards the Bank of Canada's 2 percent target without slowing the economy to an unacceptable degree. Much of the upward pressure on prices is due to supply chain issues, which are hardly unique to Canada. The Russian invasion of Ukraine will only add to international inflationary pressures, in areas from energy to wheat and fertilizers. The Bank's main hope in raising rates at this stage must be to keep inflation expectations in check as it waits and hopes for international pressures to ease. The timing for that seems to be growing more uncertain by the day.