Rising energy and food costs to push U.S. inflation rate to four per cent by fall of 2008, finds a new CIBC World Markets Report
U.S. TIPS and Canadian RRBs good investment bet TORONTO, Nov. 14 /CNW/ - CIBC (CM: TSX; NYSE) - Rising global energy and food prices are fuelling headline U.S. inflation that could hit four per cent by next fall, according to a new report from CIBC World Markets. The report finds that the U.S. Federal Reserve Board, which focuses on core CPI (excluding energy and food prices), will ignore these headline inflationary concerns in the near-term while it focuses on stimulating the economy and keeping it from falling into a recession. "These secular inflation threats from food and energy will be set aside by the Fed, which will be clearly focused on the cyclical threat to growth from a collapsing housing sector," says Avery Shenfeld, Senior Economist with CIBC World Markets and author of the report. Mr. Shenfeld notes that the Fed's focus on core CPI made sense in a world in which gasoline or food prices went up and then came back down but that four key longer-term trends are now driving energy and food inflation in the U.S. First, rapid energy demand in developing nations has stretched supply and pushed crude oil prices to record levels. Second, energy price hikes combined with a weakening greenback are increasing America's current account and trade imbalance. Third, higher energy costs are being passed on to consumers and businesses through a wide range of core items from airline tickets prices to trucking costs to petrochemical costs for products like plastic. Finally, the policy response to subsidize ethanol production has seen a rising share of U.S. agriculture devoted to growing corn for ethanol production and this has pushed up feed grain prices and in turn meat, dairy and egg prices. Mr. Shenfeld expects the Fed will cut rates in the short-term to kick- start the economy and that improvement will begin in the latter half of next year. This combined with continued pressures on energy and food prices will see headline inflation continue to increase. "If, as we expect, this proves to be no worse that a mid-cycle slowdown, the economy won't open up enough slack to materially change the trajectory for inflation when better growth resumes in the second half of 2008. "By fall of 2008, an economy that entered a slowdown with a headline inflation rate above three per cent could be facing a headline rate taking aim at four per cent. As a result, the Fed may be rushing to re-tighten (rates) before year-end 2008." The report notes that this approach will see U.S. Treasuries, and by extension, Canadian bonds, feel the heat of rising short rates, and that there will be doubts about the ability of the renewed tightening to quell more ingrained inflation pressures. On a relative basis, this will make inflation- linked bonds a better play. "Unlike the Fed's focus on core CPI, the payoff on U.S. Treasury Inflated Protected Securities (TIPS) is tied to headline CPI," adds Mr. Shenfeld. "Right now, on a 10-year TIP, the implied inflation rate as measured by the spread to nominal Treasuries, is roughly two and a half per cent. TIPS will outperform Treasuries to the extent that inflation exceeds that implicit projection over the life of the bond, or to the extent that the spread widens as inflation expectations change." He also believes Canadian Real Return Bonds (RRBs) may benefit by late 2008, although this will be muted by the lagging impact of a stronger currency in quelling import inflation. "Add in a GST cut, and we can't see Canadian CPI topping two and a half per cent at any time in 2008. As well, even if it watches only core inflation, by the Canadian definition, the Bank of Canada will be taking meat, packaged foods and other such products into account. "Finally, the implied inflation rate in RRBs has not been as well correlated with on-the ground headline inflation. Still, with inflation fears in Canada likely to escalate as the U.S. economy rebounds later in 2008, RRBs should still outperform a threatened nominal Government of Canada bond market." The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/occrept63.pdf CIBC World Markets is the wholesale and corporate banking arm of CIBC, providing a range of integrated credit and capital markets products, investment banking, and merchant banking to clients in key financial markets in North America and around the world. We provide innovative capital solutions and advisory expertise across a wide range of industries as well as top-ranked research for our corporate, government and institutional clients.