Reverting back to the 70s
05 July 2022
Presenting to the CASLA annual conference, Benjamin Tal, managing director and deputy chief economist at CIBC, provides a Canadian perspective on macro drivers that will shape the direction of the economy and financial markets. Carmella Haswell reports
Image: Benjamin Tal
The economy is facing a whirlwind of change which is seemingly reverting back to the days of the 70s. Interest rates are rising at a speed that has not been seen for generations, which could lead to major implications according to Benjamin Tal, managing director and deputy chief economist at CIBC.
The Organization of the Petroleum Exporting Countries (OPEC) is regaining its pricing power the way that it had in the 1970s. “Back then, we were in a situation where inflation was rising. Today, inflation is rising very, very fast,” Tal explains at the Canadian Securities Lending Association’s annual conference. A factor differentiating the current economical landscape from that of five previous decades is inflation expectations.
Tal defines expectations as mutant and are predicted to continue for the next two to three years. However, how long this will last is unclear. Tal says: “In the 70s, inflation expectations were all over the place, therefore wages were rising rapidly and real income was flat. That is not the case now, wages are rising but prices are rising faster.”
A focal point of Tal’s presentation revolved around the cost of bringing inflation down to 2 per cent. The Federal Reserve System will do whatever it takes to reduce inflation, even if the end result is a recession.
According to Tal, the number one source of information about inflation which shapes a person’s expectations is social media. “However, the Bank of Canada cannot tweet its way to reduce expectations, they have to show people, they have to mean business,” he says. “The only way to do that is by raising interest rates very rapidly and that is why, next month in Canada, interest rates will rise by 75 basis points — the way the Fed is doing because they have to convince people that inflation is under control.”
Tal predicts that COVID-related sources of inflation will diminish as the world transitions away from the pandemic. The primary drivers of inflation, he notes, include energy prices, supply chain, rent inflation and the labour market.
Sources of inflation
Reflecting on energy prices, CIBC’s Tal reviews several recessions over the past few decades that have been linked to energy dynamics. He concludes that oil shocks of the past were typically soon followed by a recession. “Visibly high interest rates, namely energy, were inflationary. Central banks raised interest rates and high interest rates kill the economy,” he says.
With a reduced sensitivity to energy prices, energy has become less inflationary. Over time, there has been a tug-of-war between efficiency and usage and currently efficiency is winning as furnaces have become increasingly efficient, while house sizes grow. Additionally, for the first time, oil executives are not investing after prices rise.
“When prices increase, investments in our data increase,” says Tal. “This time around, they are not doing anything because they know that green is replacing black. This implies that the economy is not getting the injection of energy that it would usually get from investment. [The implication is that], energy is much less inflationary than it used to be.”
A second source of inflation is supply chain driven, which Tal estimates to contribute 60 per cent of the inflation that is being witnessed currently. In 2021, the COVID-19 pandemic contributed to a sharp rise in the consumption of goods.
Tal explains: “Even a normally functioning supply system will have difficulties dealing with this situation, and this is not a normally functioning supply system. The demand shock is COVID, the supply shock is 85 per cent COVID-related. If you take away COVID, then the supply chain problems will disappear.
“I believe that a year from now, we will not be discussing supply chain issues in any significant way. The only risk is that supply chain pressures will not be resolved soon enough for the Bank of Canada to stop raising interest rates.”
Exploring inflationary pressures in the rental sector, Tal says that for the first time in several years rent inflation will outpace home pricing inflation. The majority of jobs that were lost at the beginning of the COVID crisis were low paying jobs, affecting persons renting their housing. Homebuyers and potential homebuyers benefited from the crisis, financially speaking, as their spending reduced and their income increased. As a result, homebuyers were in a good position to take advantage of low interest rates.
For those potential homebuyers, gifting has become a major force of impact in the Canadian market. Tal notes that one third of first time homebuyers have received a significant gift of CAD$100, 000 (US$77, 400 approx). “You cannot understand the legacy market by just looking at the price to income ratio. The biggest transfer of wealth in Canadian history was seen in three generations — people in the 90s, 60s, 30s, 20s and the demand is skipping a generation.” Tal adds.
With respect to labour market inflation, Tal observes a trend of rising wages — but with higher inflation rates impacting low paid jobs, given the difficulty in filling service roles.“I believe that COVID opened up the labour market, it is more flexible,” says Tal.
As a result, increasing numbers of people are finding positions that are equivalent and consistent with their skills. Furthermore, there is a huge increase in the participation rate among university-educated people as they see the market opening up to them. “The shortage of low wage workers is structural,” says Tal. “Maybe this is healthy as it is a signal to employers that those jobs deserve higher wages and better conditions. But clearly we have a shortage, which means that the structural change of the labour market is inflationary and interest rates will need to rise to combat this,” Tal concludes.
“2022 is the year of the tiger, the most unpredictable creature out there,” concludes Tal. “You need a working assumption about COVID. The consensus is that there will be more variants, but we will deal with it. The economy will be dancing to the tune of COVID, but we can deal with this challenge.”
The Organization of the Petroleum Exporting Countries (OPEC) is regaining its pricing power the way that it had in the 1970s. “Back then, we were in a situation where inflation was rising. Today, inflation is rising very, very fast,” Tal explains at the Canadian Securities Lending Association’s annual conference. A factor differentiating the current economical landscape from that of five previous decades is inflation expectations.
Tal defines expectations as mutant and are predicted to continue for the next two to three years. However, how long this will last is unclear. Tal says: “In the 70s, inflation expectations were all over the place, therefore wages were rising rapidly and real income was flat. That is not the case now, wages are rising but prices are rising faster.”
A focal point of Tal’s presentation revolved around the cost of bringing inflation down to 2 per cent. The Federal Reserve System will do whatever it takes to reduce inflation, even if the end result is a recession.
According to Tal, the number one source of information about inflation which shapes a person’s expectations is social media. “However, the Bank of Canada cannot tweet its way to reduce expectations, they have to show people, they have to mean business,” he says. “The only way to do that is by raising interest rates very rapidly and that is why, next month in Canada, interest rates will rise by 75 basis points — the way the Fed is doing because they have to convince people that inflation is under control.”
Tal predicts that COVID-related sources of inflation will diminish as the world transitions away from the pandemic. The primary drivers of inflation, he notes, include energy prices, supply chain, rent inflation and the labour market.
Sources of inflation
Reflecting on energy prices, CIBC’s Tal reviews several recessions over the past few decades that have been linked to energy dynamics. He concludes that oil shocks of the past were typically soon followed by a recession. “Visibly high interest rates, namely energy, were inflationary. Central banks raised interest rates and high interest rates kill the economy,” he says.
With a reduced sensitivity to energy prices, energy has become less inflationary. Over time, there has been a tug-of-war between efficiency and usage and currently efficiency is winning as furnaces have become increasingly efficient, while house sizes grow. Additionally, for the first time, oil executives are not investing after prices rise.
“When prices increase, investments in our data increase,” says Tal. “This time around, they are not doing anything because they know that green is replacing black. This implies that the economy is not getting the injection of energy that it would usually get from investment. [The implication is that], energy is much less inflationary than it used to be.”
A second source of inflation is supply chain driven, which Tal estimates to contribute 60 per cent of the inflation that is being witnessed currently. In 2021, the COVID-19 pandemic contributed to a sharp rise in the consumption of goods.
Tal explains: “Even a normally functioning supply system will have difficulties dealing with this situation, and this is not a normally functioning supply system. The demand shock is COVID, the supply shock is 85 per cent COVID-related. If you take away COVID, then the supply chain problems will disappear.
“I believe that a year from now, we will not be discussing supply chain issues in any significant way. The only risk is that supply chain pressures will not be resolved soon enough for the Bank of Canada to stop raising interest rates.”
Exploring inflationary pressures in the rental sector, Tal says that for the first time in several years rent inflation will outpace home pricing inflation. The majority of jobs that were lost at the beginning of the COVID crisis were low paying jobs, affecting persons renting their housing. Homebuyers and potential homebuyers benefited from the crisis, financially speaking, as their spending reduced and their income increased. As a result, homebuyers were in a good position to take advantage of low interest rates.
For those potential homebuyers, gifting has become a major force of impact in the Canadian market. Tal notes that one third of first time homebuyers have received a significant gift of CAD$100, 000 (US$77, 400 approx). “You cannot understand the legacy market by just looking at the price to income ratio. The biggest transfer of wealth in Canadian history was seen in three generations — people in the 90s, 60s, 30s, 20s and the demand is skipping a generation.” Tal adds.
With respect to labour market inflation, Tal observes a trend of rising wages — but with higher inflation rates impacting low paid jobs, given the difficulty in filling service roles.“I believe that COVID opened up the labour market, it is more flexible,” says Tal.
As a result, increasing numbers of people are finding positions that are equivalent and consistent with their skills. Furthermore, there is a huge increase in the participation rate among university-educated people as they see the market opening up to them. “The shortage of low wage workers is structural,” says Tal. “Maybe this is healthy as it is a signal to employers that those jobs deserve higher wages and better conditions. But clearly we have a shortage, which means that the structural change of the labour market is inflationary and interest rates will need to rise to combat this,” Tal concludes.
“2022 is the year of the tiger, the most unpredictable creature out there,” concludes Tal. “You need a working assumption about COVID. The consensus is that there will be more variants, but we will deal with it. The economy will be dancing to the tune of COVID, but we can deal with this challenge.”
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