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.

Stock Market briefing

· TSX -138.55pts to 13,203, pulled down lower again by resource shares, which fell with commodity prices

· Dow +48.03pts to 11,782

· Dollar -.17c to $93.52US Sharply lower oil prices and a broader correction among other major currencies against the greenback has helped push the Canadian dollar down almost 7% since last hitting par with its U.S. counterpart just three weeks ago. And if economic forecasts are correct, the loonie will decline further, boosting the prospects for industries like manufacturing, forest products, information technology and health care.

· Oil after falling $10 last week -$.75 to $114.45US per barrel falling to a new 3 month low as the U.S. dollar extended its rebound and more signs emerged that China's energy demand could be leveling off and traders monitored the conflict between Russia and Georgia that some believe could disrupt supplies

· Gold tanked 4% -36.50 to $820.85US per ounce to its lowest level in a year

· A strong US dollar also caused copper to hit a 6 month low

New home prices soften, construction plummets

Gary Marr, Financial Post

New home construction, fuelled by a major drop in Ontario, continued to decline last month confounding economists who now say the housing market is falling faster than expected.

Canada Mortgage and Housing Corp. said they were 186,500 new homes constructed last month on a seasonally adjusted annualized basis, a 13.6% drop from a month earlier. The pain was felt hardest in Ontario's condominium market where the construction of multiple apartment units was down 57.9% in July from a month earlier.

Paul Ferley, assistant chief economist with RBC Economics, noted the slide in housing starts was worse than many economists had estimated. The consensus was for 210,000 starts in July which would have been only a 3.6% decline from June.

"The weakness is occurring much sooner than we expected," said Mr. Ferley, adding no one is expecting the Canadian housing market to get as ugly as its United States counterpart.

"The drop in starts in July was likely slightly overstated with the weakness largely concentrated in Ontario. However, housing activity is definitely on a downward trend consistent with indications of deteriorating affordability through last year," said the economist.

Most of the country was hit by the sudden dip with Alberta and British Columbia the only exceptions. Starts rose 23% in Alberta from a month earlier and 5% in B.C. from June to July.

While much is being made of the fact that the condominium sector skewed the July numbers, construction of single family homes is also waning. CMHC said urban single starts dropped 6.6% in July from a month earlier.

Brian Johnston, president of Monarch Corp. a major developer in the Toronto region, said the problem is the housing sector just cannot compete with its own past record. Starts hit a 19-year in 2006 and dropped only marginally last year.

"I would suggest there is a worrying trend that we are seeing such significant drop offs," said Mr. Johnston. "Starts always follow sales and I can tell you sales are definitely trending down in 2008."

Mr. Monarch said the market is cooling and builders are feeling it because they are unable to raise prices at a time when some of their costs are going up. Market conditions for existing homes are the same, with sales dropping and prices flat or falling across the country.

"It's a tougher market out there. I don't think we are in panic mode, there isn't a huge concern but we are definitely slowing down to some extent," said Mr. Johnston.

CMHC said it still expects for the seventh straight year that starts will top 200,000, the strongest housing run in Canadian history.

"It's not that bad," said Bertrand Recher, senior economist with CMHC. "What you saw was a one-month blip due to the multiple starts in Ontario and that's mainly Ontario."

In the first six months of the year, condo construction soared in Ontario and now it appears that run is over. "This is a readjusting because of those strong months," said Mr. Recher.

Pascal Gauthier, an economist with TD Bank Financial Group, echoed those comments. "There will be a natural tendency to read too much into this monthly decline," he said. "We think it's important to caution observers against such knee-jerk reaction to this month's CMHC report. Residential construction is easing and should continue to do so."

Financial Post