The Return of Six Percent Inflation

by Jeff Rubin, CIBC World Markets

We haven’t seen a 6% CPI inflation rate
posted in the US since 1990 and even then
only briefly for four months. You’ve got
to go back to 1982, in the midst of the
stagflation that followed the second OPEC
oil shock, to see the last time American
inflation was clocked at that kind of pace for
any sustained period. Yet within the next six
months, there is every reason to believe that
headline CPI inflation will once again reach
that speed.
Coincidence or back to the future? You be
the judge. There seems to be at least two
major differences between then and now.
How long they last remains to be seen.
One huge difference is labor markets. Back
in the 1980s they looked quite different than
they appear today. For one thing, no one
was looking over their shoulder to see if their
plant and their job were being moved to
China. Not that China wasn’t just as cheap as
today. It’s just that it didn’t matter back then
because of all the tariff and quota protection
around home markets. For another, most
collective bargaining agreements of the day
had cost of living allowances (COLA) built
into the wage scale. Those COLA clauses
largely became self-fulfilling prophecies by
ensuring that oil price-driven inflation would
largely become self-sustaining through a
wage-price spiral.
While that may seem light years from today’s
labor market, soaring energy costs are
rapidly turning global cost curves on their
head. As shipping costs soar with tripledigit
oil prices, the once omnipotent threat
of Chinese competition is growing fainter
every day. And the same energy costs that
now protect American workers with soaring
freight costs are, at the same time, eating
their paycheques at the gas pumps.
Both are powerful incentives for COLA to
make a triumphant return to North American
wage negotiations. Particularly in highly
organized industries like steel, where soaring
freight rates are the equivalent of doubledigit
tariff protection. High energy prices give
American manufacturing workers bargaining
power that they have lacked for over a
decade, while at the same time encouraging
them to ask for larger pay raises to keep
pace with the soaring price of gasoline. And
as more and more of OPEC’s oil is diverted
to meet soaring power demands throughout
the Middle East (see pages 4-7), American
pump prices will continue to rise.
If labor markets start changing, how high will
interest rates have to rise? The last time we
saw 6% inflation in 1990, the federal funds
rate was running at around 7½%—
over
three times today’s setting. And a 10-year
Treasury bond was yielding 8½%—over
double what it yields today.
We expect that the Federal Reserve Board
will raise interest rates no less than 200 basis
points by the end of next year. History says
we will be very lucky if they don’t have to
do more.