Source: Amazon Prime Movies

By Michael O’Neill

Inflation is rising in Canada and the USA.  The Bank of Canada knows it, and so does the Fed.  The central bankers don’t see it as an issue today, but it is almost certain to become Tomorrow’s War, and Chris Pratt may not be around to save the day.

Consumers in both countries have first-hand experience, especially those people who bought a used car, built a deck, or wanted to replace outdoor furniture.   Used car prices jumped 66% in just six months in America and in between January and  May, lumber prices soared 157%.

Fortunately, the higher prices are “transitory.”  The proof is in lumber prices, which fell from $1670.00 May 7 to $712.90 on July 12.

 Fed Chair Jerome Powell cited that drop as an example of transitory inflation at the June 16 meeting. However, prices are still 9.7% higher than the January low, which is inflation.

Chart: Lumber (LBS: Nasdaq)

Source: Nasdaq

US Inflation soared 5.4% y/y in June, and when Food and Energy are excluded, it rose 4.5%.  Mr Powell described those gains as “notable” when he testified before the Committee on Financial Services, US House of Representatives, on July 14.

The gains may be notable, but they are not, in any way, actionable.   Powell and other Fed officials justify ignoring  higher prices saying, “with inflation having run persistently below 2 percent, we will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well-anchored at 2 percent.”

Stop right there!  The statement about inflation running persistently below 2.0% implies that the Fed deliberately orchestrated lower levels in the past.

That isn’t the case.  The FOMC were as baffled about weak inflation in 2019 as they are with rising inflation in 2021.

The 2019 FOMC statements all had similar wording to the following; “On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent.  Market-based measures of inflation compensation remain low.”

Simply put, the FOMC didn’t have a clue as to why inflation was persistently below their target level, so why should markets believe the Fed when they say the latest inflation increases are merely transitory.

The Bank of Canada’s inflation mandate is to target inflation in a 1-3% band, with policymakers “equally concerned about inflation rising above or falling below the 2 percent target.”  They seem to have accomplished their goal.  They said they prefer to look through “transitory fluctuations” in total CPI and focus on “core” inflation.  Core- inflation strips out the volatile components of food and energy which is supposed to better reflect the underlying trend.  They have fine-tuned their measurements and include three additional measures of  of core inflation.  They are trim, median, and common.

Despite what the BoC says, Canadian consumers do not need a whack of economic models to tell them the cost of goods and services they want to buy are rising, and rising far more than official data suggests.

Chart: Bank of Canada Inflation indicators

Source:  Bank of Canada

The US rate hike sentiment got a considerable boost after the Summary of Expectations at the June FOMC meeting projected two rate hikes in 2023.  Mr Powell said, “substantial further progress” (to achieving the Feds dual mandate) is “still a long way off.”   During the  July 14 Congressional testimony, he answered a question about inflation and higher rates saying, “it is clear that nearly all the forecasters believe inflation pressures will subside”, adding it would be a mistake to act prematurely.

The Biden administration may change that.  The government is talking about a $3.5 trillion stimulus plan, on top of other trillion dollar plans, previously announced.

FX markets are not drinking the Fed’s Kool-Aid.  They have been buying US dollars since the beginning of May, anticipating that US interest rates will need to rise sooner than expected.  The US dollar index (USDX) climbed 1.68% during that time.

Source: IFXA/RP

The Canadian dollar has outperformed against the commodity currency bloc (AUD and NZD) due to rising oil prices, and BoC rate hike speculation.  That may change since the Reserve Bank of Australia opted to end their quantitative easing program as of July 23, leading to speculation about a rate hike in August.

The Canadian dollar is vulnerable to further weakness, in part, because all the good news is priced in.  And bad news is starting to emerge.  The BoC downgraded their 2021 growth forecast from 6.5% to 6.0% in the July Monetary Policy Report.  They also lowered their inflation forecast to 2.3% from 3.0%.  Those moves suggest a domestic rate hike will lag that of the US.

USDCAD is trading just below the mid-point of its range for the past 20 years and has only been below that level for  about a dozen weeks since 2015.  Robust US economic growth fueled by trillions upon trillions of stimulus cash and the latest Opec deal which includes the UAE ,may limit oil price gains, providing additional support to USDCAD.

Fighting inflation may be tomorrow’s war but it may be prudent to plan for it today.