The Weekly Bottom Line: All About Inflation and Geopolitics

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United States Highlights

  • Inflation concerns and rising geopolitical tensions weighed on equity markets this week. On inflation and monetary policy, minutes from the January FOMC meeting indicate that most participants believe the Fed should raise rates faster than it has over the period. post-2015.
  • Retail sales beat market expectations in January, rising 3.8%. Strong receipts at auto and parts dealers and non-store retailers were behind the increase.
  • Housing starts were down 4.1% in January, but trending still at their highest level since 2006. Sales of existing homes were strong, rising 6.7% last month. The good performance probably reflects some acceleration in activity.

Canadian Highlights

  • Data released this week reinforced calls for the Bank of Canada to move on to higher interest rates. Average home prices posted their fastest monthly gain outside of the pandemic onset since 1989 in January.
  • Not to be outdone, headline CPI inflation is at its fastest pace since 1991, with broad price pressures across major categories.
  • The BoC will begin its rate hike campaign in March and its key rate is expected to reach its pre-pandemic level by the middle of next year. If inflation continues to surprise on the upside, it could get there even faster.

United States – All about inflation and geopolitics

The week started on a “beautiful” note, but the high price of roses – a fairly inelastic good on Valentine’s Day – has likely reminded the average consumer once again of the strong inflationary pressures facing the country. Concerns about high inflation, as well as rising geopolitical tensions (Ukraine-Russia) added to equity market volatility.

On inflation, the minutes from the January 25-26 Federal Open Market Committee (FOMC) meeting showed growing concern over high inflation. From our point of view, it is no longer a question of whether the Fed will raise its rates soon, but by how much. On that front, most participants believed that a faster rate of upside than the post-2015 period would likely be warranted this time around. In that vein, St. Louis Fed President Bullard reiterated this week that without prompt action from the Fed, inflation could become an even bigger problem. Bullard argued for the implementation of rate hikes, calling for a cumulative hike of a full percentage point over the next three meetings. Market quotes were in tune with some anticipation last week, briefly heading for a 50 basis point rise in March, but have since cooled.

The pace of the Fed’s hike will ultimately depend heavily on how the economy and especially interest rate sensitive sectors, such as housing, react to higher rates. A series of data reports this week showed the economy started 2022 on a decent footing. Retail sales jumped 3.8% month-over-month in January, well above the market consensus forecast for a print of 2.0%. The increases were fueled by higher receipts at automobile and parts dealers (5.7%) and non-store retailers (+14.5%). The latter, an indicator of online sales, likely benefited from an upsurge in infections last month.

Housing construction activity, meanwhile, got off to a soft start to the year, with housing starts falling 4.1% (m/m) in January. Judging by the many hurdles builders face, such as material and labor shortages, this result is not entirely unjustified. The growing absenteeism of workers infected during January’s Omicron wave also likely weighed on the pace of new construction. Still, it is important not to lose the forest for the trees. On a trend basis, residential construction activity remains near its highest level since 2006, while builder confidence remains near its highest level on record (Chart 1).

The severe housing shortage is supporting builder optimism and new residential construction activity. Existing home sales jumped 6.7% (m/m) in January, defying market expectations of a decline. This strong pace of sales weighed on inventories, plunging them to the lowest level on record (Chart 2). The imbalance is likely to keep builders busy for some time. January’s strong performance also likely represents some acceleration in activity as homebuyers try to beat higher mortgage rates. This may come at the expense of a slower pace of sales later in the year. The hunch of a rate hike has proven correct, however, with average 30-year mortgage rates climbing to around 4% in recent weeks. As the Fed moves away from ultra-loose monetary policy, higher rates will weigh on affordability, taking some more pressure off demand. This is just one of the reasons why the pace of the Fed’s hike will deserve special attention.

Canada – Cementing the appeal to higher tariffs

As is well known, house prices in Canada have followed a significant upward trajectory during the pandemic. However, that narrative took to a whole new level this week, as January data showed a nearly 7% m/m gain in the average house price. Excluding the brief period in early 2020 when activity and prices rebounded from the lockdown, this is the strongest monthly rise since 1989 (Chart 1). In particular, prices increased in all provinces. In the GTA (the country’s largest market), prices rose at their fastest pace since early 2017, when the region was arguably in the grip of a speculative bubble. Upward pressure on prices is expected to persist, as the monthly supply of properties remained at a historically low level.

Rising prices are eroding housing affordability, and this deteriorating backdrop has made it harder for first-time homebuyers to get into the market. Bank of Canada data released last month confirms this point, as it shows the share of purchases by first-time home buyers fell to 47% in mid-June last year from 53% in early 2015. At the same time, the share of home purchases made by investors is on the rise, rising to around 21% from 19% before the outbreak of the pandemic. If price growth continues at these frothy rates, these trends could continue. Or in the worst case, investors suddenly exit the market and prices adjust downward very quickly.

Home prices weren’t the only high-profile price data released this week. Consumer price inflation was also higher than market expectations in January, with the headline rate hitting 5.1% year-on-year. Seasonally-adjusted prices were up 0.6% month-on-month, and every category saw gains well above their recent historical norms. Measures of underlying inflation have also increased and inflation is spreading across all categories (Chart 2). The situation may not be better for this month either, as oil prices rose amid geopolitical uncertainties, despite some reversal this week. Additionally, blockades (notably at the Ambassador Bridge, which was resolved this week) have further strained supply chains.

Overall, these data points served to reinforce (and amplify) the narrative that rates will rise from early March. How much higher is a matter of debate. For their part, the markets expect nearly seven increases by the end of this year. The forecast we released last month called for a slower pace, with six rate hikes between March and the first half of next year. That would take the overnight rate to 1.75%, where it last held before the pandemic hit. However, if inflation proves to be a more difficult problem to solve, policymakers may be forced to push the rate even higher than this level.

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