Inflation: Up or Down?

by JDH on May 11, 2024

There are currently two competing narratives: inflation will go up, or inflation will go down.  It’s important to get it right to guide our investing decisions.

Inflation is Going Up

The “up” narrative is simple: Inflation is up, and there are no reasons to expect anything to change.  That is a compelling argument.  An object in motion stays in motion, until some external force causes it to change.

In Canada, we have massive government spending.  The federal budget, released in April, projects a $40 billion annual deficit this year and next, and it never projects a balanced budget.  We know that budget projections are always wrong, but in the past, politicians would at least pretend that the budget would “balance itself.” That is no longer the case.

Governments want to get re-elected, and the best way to get re-elected is to promise stuff, not promise tax increases, which leads to deficits.

Excessive government money printing leads to an increase in the money supply, which causes inflation.  Simple.  But there is another factor to consider:


Governments have had massive deficits for many years.  In 2020, the federal government ran a well over $300 billion deficit, yet there was no immediate inflation.  Why?  One reason is the time lag: it takes time for spending to filter its way through the economy.

The other reason and this is applicable over the last 20 years, is globalization.  We have exported our inflation.  Instead of producing goods in Canada, where you have to pay an employee $20 per hour, you produce them in China at $2 per hour.  I’m making up numbers, but you get the point.  Globalization reduces the cost of everything, so the impact of higher government spending is mitigated by cheaper foreign goods.

But here’s the problem: Canada and the USA are mad at China (and Russia and other places).  We have imposed sanctions and tariffs.  If you put a 20% tariff on Chinese goods, that increases the cost to the consumer of those goods by 20%, all else being equal.  “Made in China” is no longer something to brag about.  Canadians want Canadian jobs, so, gradually, manufacturing is returning to more friendly nations.

That’s great, but friendshoring is inflationary.  Prices will increase.

Inflation is Going Down

There is, however, a counter-narrative: Inflation has peaked and is headed lower.  Government spending peaked in 2020 and 2021.  Everyone was getting government stimulus payments.  Those payments have stopped.  That’s why the Canadian federal deficit has dropped from $340 billion to a projected $40 billion.  If massive government spending created inflation (which it did), dramatically lower spending should reduce inflation (which over the last six months it has).

The key here is the time lag.  You receiving a Canada Carbon Rebate cheque on Monday does not cause inflation on Tuesday.  It takes time for that money to enter the economy and increase prices.  The same is true in reverse: lower stimulus payments lowers inflation, but not immediately.

The time lag appears to be in the range of 16 to 18 months, and that’s why I am of the view that inflation will continue to drop through the summer, and could bottom out at zero.

To be clear, I’m not saying inflation will be low forever.  As the impact of lower government spending filters through the economy, inflation will drop, but governments continue to run deficits.

It’s the rate of change that matters.  As governments ramp up spending (to get re-elected) inflation will return.

I am of the view that we will see lower inflation in the summer, and higher inflation in 2025.

I therefore believe that Canada will cut interest rates, probably starting in September, because if inflation is lower, they can afford to cut.

I could of course be wrong, or I could be correct but my timing could be wrong.

We shall see.

The “play” here is to buy hard assets (like gold and Bitcoin) and long bonds (if you agree that interest rates will fall).

Most mainstream economists disagree with me, so I’m likely wrong, but that’s the way I see it.

Thanks for reading.  See you next week.