- How we got here
- The lag effect
- Relief in 2023
As summer turned to fall, we had the pleasure of increased in-person meetings and presentations. It’s been a welcomed change. Video calls can feel regimented and formal while in-person interactions are more free flowing. People also tend to be more engaged in person and are likely to ask questions they may not feel comfortable posing through a screen. Not surprisingly, one uncomfortable topic that’s been on a lot of people’s minds continues to be inflation.
How we got here
To understand how we get out of the current inflationary environment it’s important to remind ourselves how we got here. We’ve spent much of the past two years talking about supply chain bottlenecks, product shortages, surging home prices and a lack of labour. But if inflation is an ailment, these are just symptoms of the disease – not the cause of it. Sadly, the primary cause would be COVID-19 stimulus.
Stimulus has taken two forms. The first is monetary in the form of ultra low interest rates. As Figure 1 shows, the Bank of Canada cut its target rate at the outset of the pandemic to levels only seen once in the past thirty years, and kept them there for an extended period of time.
While low rates were successful in supporting an economic recovery in 2020, the side effect was increased borrowing, higher leverage, greater spending and lots of speculation. The Bank of Canada has worked quickly to reverse rates this year, increasing the target rate by 3.5% already in 2022 with expectations for more to come. Seldom has the bank increased rates as quickly as it has this year and rates are now at a level not seen since the financial crisis. Borrowing now has a cost once again.
Figure 1: Bank of Canada Target Rate
The second form of stimulus was fiscal, as the government broke the budget by ramping up spending on a range of programs. Figure 2 shows money supply growth in Canada over the past 30 years. The measure shown is M2, which is accessible, and liquid sources of money such cash in circulation, chequing and savings deposits, and money market accounts among other sources. The payments were so generous that the money supply grew by 20% at its peak.
It’s common for the money supply to grow during a recession as governments spend to stimulate the economy (2008/2009 is a good example), but this growth was almost unprecedented. In fact, money supply growth at this level is more indicative of wartime spending than economic stimulus.
Of course, much of the money was spent which has contributed greatly to inflation. The money supply growth has since normalized with many of the government programs no longer running, but the damage has been done.
Figure 2: Canada - Money Supply, M2
The lag effect
With much of the stimulus now reversed in rapid fashion, why hasn’t inflation also come down rapidly? Unfortunately, there’s a lag effect. When rates rise, some parts of the economy are hit immediately while many others take time to be affected.
One area that’s been hit quickly are home sales. Mortgage rates have risen dramatically, which has crushed sales and listings as affordability declined. Over the next little while, we should see an impact on other areas of the housing market such as renovations and construction. As contracted work gets completed, there will be fewer projects in the hopper to replace the backlog.
We’re already seeing inflation in goods start to come down. Services such as hotels and restaurants are often some of the last areas to feel the impact. To complicate matters, some of the stimulus money that governments handed out is still out there waiting to be spent. This will support higher prices until it works its way through the economy.
Relief in 2023
Current forecasts predict that inflation in 2023 will be much lower than in 2022, but still elevated (think 3-4% instead of 6-8%). Although it’s a welcome relief from this year’s price increases, it still means that rates will be sticky to the upside. We could see rate cuts sometime next year, but nothing too significant unless inflation shows sustained signs of moving towards the Bank of Canada’s target of 2%.
In the meantime, markets are like a coiled spring waiting for the “pivot” from rate increases to stabilize or lower rates. We saw this in October as momentum built for the pivot and stocks rallied, only to be disappointed in early November as central banks continued to insist that rates will go higher from here.
Central banks and governments have taken the punch bowl away from the party and the economy is weakening, with a recession being increasingly likely. It may seem logical to stay out of the market and wait for more clarity on the economic outlook. However, bull markets usually start before the economy has bottomed, with rate cuts as a significant trigger and some of the strongest gains are seen at the start of new bull markets. It’s another reason to avoid trying to time the market and to stay invested.
Sources: FactSet, Desjardins
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