A Long Way From Normal

Lingering COVID-19 concerns and the threat of inflation imperil the return to normal, according to RBC's Chief Economist, Craig Wright.

Key insights

  • The biggest risk is how countries manage inflation and whether higher prices get baked in with successive COVID variants.
  • Monetary policies are a long way from normal, and hazards loom if authorities are not vigilant.
  • It’s not all dismal for markets, if inflation is checked and there’s a “normalization” of interest rates.

It is a crisis that seems impervious even to the healing power of time.

The rapidly-morphing pandemic is sparking inflation while threatening to derail growth, a problem not seen in a long time.

Prices are surging in the West and one solution seems clear: fix the snags in the global supply chain and get people back to work so goods can flow to meet demand, thereby easing price pressures.

But Craig Wright, RBC's Chief Economist, warns it might not be that simple, because the heady inflation numbers could prove more stubborn than transitory if monetary authorities do not get on top of the problem.

“If we see panic inflation, expectations become unanchored," Wright said in an interview. “That gets pretty ugly, pretty fast. I think the biggest risk right now is where we're headed on inflation because it's contingent on policy response."1

He believes a portion of recent inflation can be blamed on so-called "base effects," where prices are rising after falling during the onset of the pandemic. But the issue is whether the expectation of higher prices gets baked in with successive pandemic variants.

COVID waves create new hazards

Each COVID wave undermines growth forecasts and potentially forestalls action by governments to take the foot off the accelerator. Yet hazards loom if monetary authorities are less than vigilant about price pressures.

Said Wright, “If inflation expectations shoot higher, then it's almost a self-fulfilling prophecy. So to some degree, a little more restraint from monetary policy will cool demand but importantly send a signal that central banks are not asleep at the switch."

“I'm talking about raising interest rates around the globe and pulling back on quantitative easing. You have to look at the context of what ‘normal’ is and we're still a long way from normal."

Monetary authorities in Canada, the U.S. and Britain turned more hawkish on interest rates in the final weeks of 2021.

You have to look at the context of what "normal" is and we're still a long way from normal

The Federal Reserve is expected to raise interest rates three times in 2022 and taper its bond-buying program more quickly than previously envisioned. In December, the Bank of England raised rates for the first time in three years, while Canadian monetary authorities are poised to raise borrowing costs beginning in April.

Don't call it tightening

Markets are jittery about rising rates, worrying that the treatment could be too harsh and spark a market correction. Canada and other countries are winding up fiscal stimulus while central banks are also tapering their massive bond-buying programs.

The move to wean economies off artificial support is yet another potential challenge, but Wright notes that central banks are not anywhere close to a tightening of monetary policy.

“They're taking the foot off the accelerator, they're not slamming on the brakes," Wright said, emphasizing that tightening does not happen until rates move from accommodative to neutral. “So still an accommodative policy but hopefully less accommodative going forward, which should keep inflationary pressures in check and that should prevent some of the harsher outcomes."

The Great Divergence?

Another concern is China. Called the Great Divergence by some analysts, the world's second-largest economy is taking measures to ease—a sharp contrast to Western countries where overheating is paramount.

“China will continue to be a significant player in the global economy," said Wright. “It's just that they'll be printing smaller growth rate numbers. They're dealing with what the global economy is dealing with in terms of demand relative to supply, they're dealing with inflation worries, but they're also trying to recalibrate their domestic economy."

That does not mean Western countries are on easy street.

“So what we're seeing is pressure on the global supply chains, and it was taking place when the producers, many in the developing world, were shut down during COVID," he said.

China, the world's second-largest economy, is taking measures to ease—a sharp contrast to Western countries where overheating is paramount

Canada's performance on the employment front has been strong. While the U.S. has struggled to recoup the jobs lost to COVID, its northern neighbour has already recovered the positions it lost during the shutdown, and job creation in recent months is exceeding expectations.2

In November, Canada's unemployment rate fell to 6.0 percent, a sharp drop from 9.1 percent posted at the beginning of the year.3 That's good news for Canada but grist for monetary authorities to move sooner than expected on rates, according to some market watchers.

It is more of a mystery why the U.S. has been hit harder with the so-called Great Resignation.

“So there's something else going on there but I think over time we'll get a clear line of sight, and it's still a bit early to gauge exactly how permanent that is," Wright said.

Not all dismal?

Trying to get a clear line of sight on employment and how countries are performing in getting price pressures in check is key.

For Wright, the economic healing can occur if authorities keep inflation front and centre. “If the economy is strong and inflation is in check, and we see a normalization of interest rates, that's not a dismal world for financial markets, right?"

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  1. RBC Investor & Treasury Services (November 2021) Interview with RBC Chief Economist, Craig Wright
  2. Statistics Canada (September 2021) Labour Force Survey
  3. Statistics Canada (November 2021) Labour Force Survey