October 25, 2021 | The Complicated Path Forward

Consumer price inflation ripped higher in September, surging 4.4% year-over-year, the fastest pace of price increases in 18 years. Let’s discuss this further. We have an inflation problem and the Bank of Canada remains of the view that inflation will be transitory. Although they really can’t say otherwise, for if they did it would only spur a further rise in consumer inflation expectations. After all, inflation is at least partially a psychological phenomenon. In other words, we need to keep the masses calm.

This leads us to the next point. Consensus now believes interest rates must rise. After all, inflation is above the Banks mandate, this must mean the Bank will do the noble thing and raise rates? Markets are now pricing in four interest rate hikes from the Bank of Canada by the end of 2022. But wait, it gets even better. The brain trusts at ScotiaBank are now calling for eight rate hikes by the end of 2023. This would bring the overnight interest rate to 2.25%, higher than the previous tightening cycle of 1.75% despite an enormous amount of debt added since the last tightening cycle.

Has everyone forgotten that Canada’s total non-financial debt to GDP sits at a staggering 343%? How many rate hikes do you think Tiff Macklem and Co will be able to sneak in before blowing something up? My guess is a lot less than 8 and probably less than 4.

Furthermore, the Bank of Canada does not perform monetary policy independently. Monetary policy is globally coordinated, with Canada taking their cues from the US, Europe and Japan. We discussed this at length in our new podcast, aptly titled ‘The Loonie Hour‘. Neither of these major central banks are signalling imminent rate hikes. In fact, they’re now trying to coordinate a tapering of their massively inflated balance sheets, which sit at over $30 trillion and are largely responsible for providing liquidity across global financial markets. Tapering their asset purchases is the first step, and it won’t come easy with global debt to GDP sitting at 365%, meaning any tightening that leads to an economic slowdown will only make the debt burden harder to service.

In other words, central banks are trapped, they should be raising rates to fight inflation but it’s the last thing they want to do. As my friend Jared Dillian put it, Central banks won’t raise rates until the pain of inflation is greater than the pain of a recession.

I think the risks are elevated here, and we are setting ourselves up for a policy error. The implications are significant, particularly in Canada with a highly levered housing market. Canadians have enjoyed a debt buffet, particularly over the past year. In the first half of 2021, residential mortgage debt growth continued ticking up to levels not seen in a decade. As of June 2021, total outstanding residential mortgage debt stood at $1.73 trillion, representing a 9.3% increase from a year prior. Variable rate mortgages now make up over 55% new mortgage originations, further complicating the path forward for the Bank of Canada.

Again, the normal path forward here is to raise interest rates, but this is not a normal financial system. It has been on life support since 2008. Don’t be surprised if real rates remain negative for a very long time.

We’re about to find out.

Three Things I’m Watching:

1. Major central bank balance sheets closing in on $30 Trillion. Tapering asset purchases will not be easy. (Source: Yardeni)

2. Real mortgage rates in Canada are now negative 2.8%. Yes you read that correctly. (Source: Ben Rabidoux)

3. Residential mortgage credit growth jumped by 9.3% in first half of 2021. Fastest pace in over a decade. (Source: CMHC)

Steve Saretsky October 25th, 2021

Posted In: Steve Saretsky Blog

Next: Gold, Gold Miners, Copper, Crude Oil, Natural Gas »