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

Nov 14, 2007, 00:00 ET from CIBC World Markets

    TORONTO, Nov. 14 /PRNewswire-FirstCall/ - 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:
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 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
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SOURCE CIBC World Markets