David Stonehouse, Senior Vice-President at AGF Investments, highlights CPI components to watch
Last week’s July CPI report from the U.S., which showed inflation cooling to 8.5% from 9.1% in June, provided a modest and much-needed dose of relief to investors. But among many other open questions, investors are asking: should we expect inflation to remain elevated from here? And if so, where are prices expected to stay up?
“A prominent component of inflation is related to shelter – housing, rent and those sorts of items. And that's tended to be pretty sticky,” says David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments at AGF Investments. “Depending on which metric you're using, that's a quarter to 40% of the total inflation calculation.”
In the latest data from the U.S., Stonehouse says sheltering costs ticked down slightly, but were still elevated at the 6% to 7% range. Even if inflation is past its peak, he says that component has the potential to persist for some period of time.
Wage inflation, a point of focus given the recent strength in labour markets, could also continue at an unhealthily strong pace. A union representing 2,500 Boeing defence employees recently negotiated a new three-year contract that includes an average of a 14% general wage increase over three years. Workers in certain areas of government have been lobbying for double-digit wage increases over the next few years. Companies in certain industries, including financials and pharmacists, have also been offering signing bonuses amid a continuing war for talent.
“Wages tend to be among the stickiest of all, and it does not look like [they’re] coming down quickly yet,” Stonehouse says.
After two-plus years of pandemic-induced lockdowns, consumer demand has rotated from goods to experiences, making services another area to watch for inflation prospects. Given the areas of constraint in the healthcare industry, as well as secular demand from the aging population, medical services could also be a source of ongoing increases in inflation.
“When we look at the sticky components of inflation, 60% of them are in the mid- to upper-single digits or more in terms of their year-over-year growth rate. And that's a concern,” Stonehouse says. “It means that even as we pass the peak, it may be difficult to see inflation abate quickly.”
Beyond concrete trailing data on inflation, central banks and market observers are looking at inflation expectations. That depends on several factors, including consumers’ belief in policymakers’ ability to keep prices in check. The higher those expectations go, the greater the risk that they turn into a self-fulfilling prophecy.
“We saw some very welcome news there last month. Five-year forward inflation expectations dropped from the low 3% range to the high twos,” Stonehouse says. “But it's going to be very important to monitor that going forward, and for central banks to keep that in check. I think it is going to be among the most important factors determining the pace of moderation.”
Getting inflation down to the 5% to 6% level, from its current 8% to 9%, would obviously be a plus. But in Stonehouse’s view, the Federal Reserve and the Bank of Canada wouldn’t feel comfortable declaring a victory in their inflation fight until it cools below 4% into the 3% range.
“They've certainly got the 1970s in the back of their mind. So there's still more work to be done over the next few months before they start to feel that inflation is not becoming entrenched,” he says. “We may be past the peak of inflation, but if that doesn't moderate fairly quickly, that still leaves the central banks needing to address this further, as they've been articulating over the last few months.”
In Canada, inflation still has the potential to rise. After Statistics Canada reported annual CPI reached 7.7% in May, the agency said it accelerated to 8.1% the following month. The CPI report for July, which comes after the BoC hiked its policy rate by 1% to reach 2.5%, is expected tomorrow.
“It'll be interesting to see what the July data show. Fortunately, I think we'll see a much better number on the energy front, just like we did in the States,” Stonehouse says. “But the overall core numbers are likely to still show some degree of rising … We’ve still got some work to do on that front.”