In the United States, and to a lesser degree in Canada, the combined impact of pandemic stimulus, remote work, microscopic interest rates and soaring oil prices is shattering expectations and fuelling the worst outburst of inflation in decades.Jonathan Ernst/Reuters
Economists spent this week debating whether an inversion of the widely followed yield curve really does signal a U.S. recession ahead. I spent the week pondering the less-followed nephew indicator.
My nephew (a Canadian American) and his wife are young folks saving up for a house. For the past three years, they have rented an apartment in a nice but less-than-swank building in St. Petersburg, Fla. This year, their annual renewal notice dropped through the mail slot with a nasty surprise: Their rent was going up 25 per cent.
Appalled, they called the building manager and asked if this could possibly be true. Yep, they were told. They were actually getting a preferential rate for existing tenants. In fact, their rent increase was less than the regional average.
If nothing else, their story demonstrates how far away from normal many parts of the North American economy still are. In the United States, and to a lesser degree in Canada, the combined impact of pandemic stimulus, remote work, microscopic interest rates and soaring oil prices is shattering expectations and fuelling the worst outburst of inflation in decades.
In the case of my nephew, inflation is reflected most dramatically in galloping rent increases – the result of a mass migration of remote workers and early retirees to his state, as well as higher costs for inputs ranging from wages to electricity.
Here in Canada, meanwhile, price pressures are playing out in everything from soaring gas bills to double-digit surges in real estate values.
It all adds up to a nasty problem for central bankers, the experts who are supposed to keep inflation in check.
Which brings us back to the yield curve. This indicator, a weather vane of economic activity, measures the gap between shorter-term bond yields and longer-term bond yields. The curve normally curves upward – that is, longer-term bonds pay more than their shorter-term equivalents.
When that pattern inverts – when shorter-term bonds start paying more than their longer-term counterparts – a recession has reliably followed in the U.S. (The Canadian experience is more mixed.) Essentially, the market is saying it expects interest rates to spike in the near term as central banks hike borrowing costs to restrain inflation, but then to fall further into the future as a result of the slowdown that will follow.
So cue the alarm when a key part of the U.S. yield curve inverted this week. The news spurred cries of concern from people worried about a possible recession ahead. It also evoked retorts from some economists who argued that if you looked at the inversion just right it actually meant nothing.
One of the more intriguing ways to think about the situation is to ask yourself just how high interest rates would have to go to tamp down rising prices in an economy where rents in some prime U.S. cities are jumping 25 per cent a year. And, for that matter, where home prices in both Canada and the U.S. are soaring by more than 17 per cent a year.
It could take more than you think. Both the Bank of Canada and the U.S. Federal Reserve have begun raising their key rates with quarter-percentage-point bumps, which brings them to all of 0.5 per cent at most. But such mild measures seem trifling compared with the tsunami of rising prices. Consumer price inflation is running at 5.7 per cent in Canada and 7.9 per cent in the U.S.
Larry Summers, the former U.S. Treasury secretary, has said he thinks the Fed will have to boost its benchmark federal funds rate to a range of 4 per cent to 5 per cent over the next couple of years. It will take massive hikes of that magnitude to get interest rates above inflation rates and meaningfully tighten monetary policy in real terms, he argues.
The bond market is not as alarmed as Mr. Summers, but is still registering concern. Five-year break-even rates, a measure of the inflation that U.S. bond investors expect over the next five years, have surged north of 3 per cent in recent weeks. That is well above the Fed’s comfort zone around 2 per cent.
If there is good news here, it is that people don’t expect high inflation to become permanent. Forward rates that measure what the market expects five-year inflation expectations to be in five-years’ time have barely budged from prepandemic levels.
One way to read these apparently conflicting signals is to say the market is still confident that the Fed has matters in hand. Bond investors expect inflation to roar over the short term, but remain assured that the central bank will do whatever it has to do to bring it back under control within the next five years.
The question du jour is whether taming inflation in the short run will require raising interest rates to the point where they precipitate a U.S. recession. Many economists say a downturn is improbable given households’ high level of savings and a booming job market. They argue that central banks’ bond-buying programs have pushed down long-term bond yields and distorted the normal meaning of the yield curve.
Others aren’t embracing that comforting notion. David Rosenberg of Rosenberg Research pegs the odds of a U.S. recession at 50 per cent. “Soft landings are elusive – the Fed may need to cause a recession to slow inflation,” Shahid Ladha, a strategist at investment bank BNP Paribas, writes. For his part, Mr. Summers argues that “at least a mild recession” will be necessary to bring price increases back into line.
Whether you’re a Canadian investor or a St. Petersburg renter, the message seems clear: Brace for turbulence. After a long period in which ultralow interest rates have coddled expectations, the risks are growing.
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