Signs of an ugly return of the inflation monster were creeping in on both sides of the North American border even before sweeping tariffs ushered in by President Trump that are expected to hit business and consumer pocketbooks hard by the second quarter. As a result, expectations for continued interest rate cuts are quickly evaporating.
In February, Canadian headline inflation was slightly hotter than expected as a sales tax holiday ended. However, looking beyond this temporary factor, the three-month annualized trend in core inflation tracked above 3%, signaling that core inflation is beginning to once again grind higher than the range of between 1% and 3% that the Bank of Canada prefers.
On the other side of the border, the U.S. Federal Reserve’s preferred inflation metric, the core personal consumption expenditures, or PCE price index, rose 0.4% month over month in February – a slight acceleration compared to a 0.3% gain in January. In year-over-year terms, core PCE inflation rose to 2.8% from 2.7% in the prior month.
More troubling, especially for central banks, is that inflation expectations are also heating up sharply. For example, in March, the University of Michigan's U.S. consumer sentiment survey pointed to a sharp increase in one-year inflation expectations to nearly 4%. Meanwhile, the expected change in inflation rates five years out surged to nearly 5%, the highest in 35 years.
Central banks are extremely concerned about inflation expectations because they influence the consumption habits of businesses and consumers, which in turn affects the economy's stability. As tariffs begin to directly raise the prices of everything from food to cars, higher expected inflation will ultimately create a doom loop of higher prices and weakened spending and investment.
Economists call this stagflation, a situation that ultimately puts central banks in a bind as they try to balance the hit to demand against higher prices, supply chain disruptions, and the risk of rising inflation expectations.
Markets are already pricing in this situation. Expectations for continued Fed interest rate cuts are evaporating. North of the border, the Bank of Canada has been in an aggressive cutting mode over the past year but has indicated it will be less inclined to cut much deeper due to growing inflation risks. This, even as Canada’s economy is poised to slip into a prolonged recession caused by the trade war.
Real estate not much of a stagflation hedge
Investors often look to real estate as a reliable hedge against inflation. That’s because the operating income derived by real estate typically grows at or above the rate of inflation. Over the long term, real estate investors can also realize above-inflation value gains from property appreciation. Over the past two decades, real estate on both sides of the border have provided exactly that.
Unfortunately, few property types are likely to continue accomplishing this given the current economic situation. For example, in Canada, a combination of elevated supply and receding demand is causing a significant slowdown in property rent growth. As a result, most property types, especially offices, are unlikely to see rents increase by an average of more than 2%, while inflation is expected to materially pick-up to over 3%.
Meanwhile, the prospects for any appreciation in property values appear to be limited given that interest rates are unlikely to materially fall and could even ultimately be raised higher due to the protracted inflation risks caused by tariffs.