Why the jury’s still out on inflation's future trajectory

Headline CPI figures have dipped, but questions remain around supply, demand, and policy-tightening impacts

Why the jury’s still out on inflation's future trajectory

Over the past several weeks, consumers and investors looking for any hint of relief from months of surging prices might have gotten what they wished for from economic data out of Canada and the U.S.

The official July CPI print in the U.S. came in at 8.5%, easing slightly from 9.1% in June. In Canada, headline inflation for July was 7.6%, a cooldown from 8.1% in the previous month.

The data could be an indication that after starting from behind the curve, the aggressive anti-inflation campaigns waged by policymakers at the Federal Reserve and the Bank of Canada are starting to pay off. But according to David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments at AGF Investments, there are other moving parts to take note of.

“Supply chain bottlenecks – which was one of the factors influencing the substantial rise in inflation earlier this year – still persist, but they have started to ease to some extent,” Stonehouse says. “Commodity prices have also begun to come off for a variety of reasons, including a supply pick-up in some areas and easing demand.”

Stonehouse points out that prices of certain agricultural foodstuffs and energy-related commodities have moderated from the substantial spike they experienced following the invasion of Ukraine. Demand for gasoline, he notes, has softened as consumers adjust their travel plans and driving habits in response to surging prices.

Another factor in the equation has been the shift in the margin from goods to services, as consumers coming out of pandemic lockdown unleash their pent-up demand for experiences outside the home. That appetite has been difficult to address in some sectors, however – cancellations at airlines and airports struggling to accommodate rapid increases in volume have made many headlines this summer – which has caused some softening of demand on the services front as well.

“There’s also the base effects. We're working our way off some pretty high numbers last year that are starting to percolate through and result in a moderation in inflation,” Stonehouse says. “Both the Fed and the Bank of Canada have really ramped up hard in terms of their tightening policy only since March, and that tends to work with a six- to 12-month lag … I think we’ll see the impact of monetary policy tightening continue to weigh on inflation as the next few quarters unfold.”

The winds favouring an easing of prices appear to be gathering, but the jury’s still out on where inflation will go from here. While the CPI in the U.S. came in cooler than expected, Stonehouse notes that food prices haven’t shown that same deceleration. Raw commodity prices have also descended to their original levels from before the Russia-Ukraine conflict first broke out, reflecting better-than-feared output of certain crops in certain areas.

Oil prices have declined from nearly $130 a barrel to the $90 range. Whether there will be more price easing ahead hinges on certain questions: will the softened demand for travel – and by extension energy – continue? Will central banks’ tightening policy continue to reduce overall demand? Or will demand increase this winter as problems with natural gas in Europe spills over across the pond?

“Clearly, something like a resolution of the Ukrainian conflict would probably result in a pretty quick drop in commodity prices,” Stonehouse says. “But conversely, if the Chinese economy were to open up more – and so far, they're still toeing the line on a pretty restrictive policy around COVID – that could result in an expansion of commodity prices again.”

The bottom line from Stonehouse’s perspective is that while the peak intensity of headline inflation may recede, the stickier elements of core inflation such as rents and wages are likely to remain elevated. As a result, core inflation is likely to remain stubbornly high relative to recent historical norms, which should prolong the battle the central banks are waging through tight monetary policy.