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The Economist vs. the Historian: Two Expert Views on Rising Inflation

December 2021

Michael Gregory

Deputy Chief Economist and Head of U.S Economics, BMO Capital Markets

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Laurence B. Mussio

Canadian Business Historian, Author, Professor, Management Consultant and Special Advisor to Senior Executives

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​The rate of inflation is surging across North America. In October, the Consumer Price Index (CPI) rose 4.7 per cent year-over-year in Canada, and 6.2 per cent in the United States – both around 30-year highs. It's a trend that could have profound implications for the economy, our customers and our business.

To learn more, we spoke with two BMO experts: Michael Gregory, Deputy Chief Economist and Head of U.S Economics; and Dr. Laurence Mussio, business historian and Special Advisor to the Office of the CEO.

Central banks have kept inflation at around two per cent for decades. Why is it rising now?

Michael Gregory: There are a number of factors at play. One is supply chain bottlenecks. These have been caused by the impact of the pandemic in some countries, but also by climate change. Look at the global microchip shortage: Two thirds of the supply comes from Taiwan, which has experienced a major drought, and you need a lot of water to make microchips. At the same time, demand is high because pandemic relief programs have put a lot of money in peoples' pockets, and they're ready to spend.

Another important factor is wages. Workers are feeling empowered to quit their jobs and go where they can earn more money. And businesses are passing the costs of higher wages and other expenses onto customers.

What have we learned from previous inflationary periods?

Laurence Mussio: One thing we know is that inflation can generate massive political volatility. The chemistry between spiralling prices and static middle-class incomes has often produced explosive social instability and deepening inequality, as it did in the contentious political environment of the 70s and 80s. This week, Darrell Bricker at IPSOS declared that inflation was "coming up like a bullet" as a concern for Canadians – and that has huge potential to sideswipe other public policy priorities.

Michael didn't mention government spending as a cause of inflation, but it seems like one to me. The U.S. administration's fiscal and monetary stimulus, which is on a scale historically closer to World War II levels, has every chance of setting off massive inflationary pressures.

What can we expect in the near term?

Michael Gregory: I liken this to a game of whack-a-mole – once one supply constraint has been dealt with, another pops up because demand is so strong. And in the meantime, inflation will continue to run high.

When inflation will peak and how much resistance there will be on the downside depends on how those bottlenecks get resolved. Our team does think it will be more problematic than what the Federal Reserve is saying.

The good news is that we likely won't be going back to the crazy inflation of the 1970s, because central banks are now very good at dealing with it. They can raise interest rates, and even if they only hike them to a long-run neutral level – where it doesn't stimulate or restrain the economy – that will help to cool the situation. It's like taking your foot off the gas but not applying the brake. I think we'll see the first interest rate hikes from the Bank of Canada by mid-next year, if not earlier. The Federal Reserve will likely follow, perhaps with a little lag.

Laurence Mussio: My concern is that central banks can't raise rates too much or too little – they need a goldilocks approach. If the 70s aren't the right historical analogy, consider the European Central Bank in 2011 or 2012. They decided to cool down inflation by raising interest rates and ended up tanking economic growth and making a bad debt crisis even worse. But maybe that's not the problem in 2021. Maybe the problem is that some governments have concluded that the only lesson of history is to "go big" – ignoring the bigger and more painful lessons of our relationship with inflation.

Michael Gregory: Fair point, Laurence.

A couple of other things are worrying me, as well. First, even short-term inflation can trigger behaviour changes that exacerbate the situation. Every business leader I talk to says they're padding their orders because they're worried about product supply and they think prices are going up – which they will, because everyone is padding their orders!

Second, people have a lot of money set aside that they can use to offset higher prices, and this will have an inflationary effect. In most situations rising prices are self-correcting; people and businesses have budget constraints, so real demand slows as prices go up. This time it's different.

What does higher inflation mean for an advisor’s business?

Michael Gregory: As interest rates go up and the spread (the difference between what banks pay depositors and what they charge for loans) has room to widen, it should have a positive impact on bank revenues.

However, I think the real opportunity is in the advice advisors provide to customers and clients. A consistent inflation rate of three or four per cent rate is double what most businesspeople and investors have experienced over many years. It's a new world.

Look at financial planning, for example. Most baby boomers have planned for two to three per cent inflation. A lot of them will have to ask themselves, have I saved enough just in case?

People will need to plan better, and that's where advisors can help.

Laurence Mussio: I also think inflation may change the way bank leaders manage the change to their business. Sure, banks are seen as inflation winners, but life may get more interesting in a sustained inflationary environment. Think credit and market risk. Think about the effect of a tightening on M&A activity and increased revenues from public offerings. Inflation and volatility also negatively impact public perception of banks in a way that we've not experienced since the Great Financial Crisis.

Thankfully, Canadian bank leaders can rely on a good set of Canadian advisors to augment their own strategic thinking with the critical long-run perspective they need to make smart choices – that's why Michael and rest of the economics team are so heavily in demand for interviews these days.

For more information, contact your Regional BMO Global Asset Management Representative.


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