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BMO Economics Special Report: A Worrisome Threesome

Research & Strategy January 03, 2023
Research & Strategy January 03, 2023

 

Businesses on both sides of the U.S.-Canada border face a trifecta of interlinked macroeconomic events: high inflation, rising interest rates and a pending economic slowdown. Until inflation falls meaningfully, both the Federal Reserve (“Fed”) and the Bank of Canada (“BoC”) will likely continue raising policy rates and then keep them at restrictive levels. But, in both countries, current interest rates are already proving onerous for some sectors such as housing. And, as past rate rises continue working their way through the economy, GDP downturns are now appearing on the horizon. 

How high policy rates go and how long they remain elevated, and, ultimately, the depth and duration of any recession, is contingent on the inflation outlook. Inflation accelerated starting in the spring of 2021, reflecting a mix of strong demand and constrained supply. From under 3% y/y at the beginning of that year, CPI inflation hit four-decade highs of 9.1% in the U.S. and 8.1% in Canada to start the summer of 2022. However, it has since stepped down from these peaks.

The pandemic caused a huge disruption to global supply chains. As restrictions loosened and pent-up spending was unleashed, assisted by massive fiscal and monetary stimulus, supply lagged. The persistent gap between demand and supply stoked inflation pressures, which were then augmented by Russia’s invasion of Ukraine. That region is a major global producer of energy, agricultural products and metals, which pushed many commodity prices to record highs.

However, in the wake of policy tightening by numerous central banks, concerns about global economic growth started mounting. Suddenly, market worries about the supply of key commodities amid the Ukraine war shifted to concerns that there would be adequate demand for them. Most commodity prices have since moved below pre-invasion levels.

As demand slows from high interest rates, the gap between demand and supply is narrowing and easing inflation pressures along the way. After peaking in December 2021, the New York Fed’s measure of global supply chain pressures has been trending down and currently hovers around two-year lows. Even the poster child for global supply shortages–microchips–is steadily improving. This allows the supply of (for example) new vehicles to catch up with slowing demand to alleviate the upward pressure on vehicle prices.

Consequently, inflation has probably already peaked (pending what this year has in store for energy prices). The latest readings were 7.3% in the U.S. (down 1.8 ppts from the peak) and 6.8% in Canada (down 1.3 ppts), in November. Although turning the corner is important, the more pressing concern for central banks is how readily these rates return to their 2% targets. And they’re scrutinizing core inflation to discern the underlying trends.

For the Fed’s preferred inflation barometer, the PCE price index, the core (excluding food and energy) measure was up 4.7% in November, after hitting four-decade highs earlier in 2022 (5.4%). The annual changes for the BoC’s core metrics (CPI-Trim and CPI-Median) were in the 5.0%-to-5.3% range (averaging 5.15%), budging little from their summer peaks. Both central banks still have work to do to get core rates back around 2%, particularly because extremely tight labour markets and consequent wage growth are becoming a dominant driver of core inflation.

On both sides of the border, jobless rates have been probing multidecade lows while wage growth has been punching multidecade highs. In the U.S., average hourly earnings (for production and nonsupervisory employees) were up 5.8% y/y in November. Although down from earlier peaks, this was the 17th consecutive reading above the 5% mark.  Apart from the pandemic-related spike in April-May 2020, the latest results are the highest in 40 years. In Canada, average hourly wages remained at 5.6% y/y in November, a 22-month high that surpassed all pre-pandemic readings.

Reflecting the fact that the demand for labour greatly exceeds supply, there were 10.3 million job openings across the United States in October. The job vacancy rate (measuring unfilled labour demand) was 6.3%, compared to a pre-pandemic norm in the 4%-range. There were almost a million job openings across Canada for a 5.4% vacancy rate in Q3. As businesses scramble to hire and retain workers, and as workers struggle to keep up with cost of living increases, wages are being bid up for all skill levels. Firms are also forced to look at automation and other capital spending to mitigate labour shortages. 

Much like goods and services, the Fed and BoC are tightening policy to align labour demand and supply by dampening demand to forestall any further formation of a wage-price spiral. America’s recent juxtaposition of 40-year-high growth rates for both wages and prices suggest that such a spiral has already started to take root. That’s another reason why central banks are raising rates well into restrictive territory, which kicked in above 3% in both countries.

As of December, the Fed has already raised rates by 425 bps to the 4.25%-to-4.50% range after a 50 bp-hike on the 14th that followed four consecutive 75 bp rate hikes. The BoC has 400 bps of rate hikes already racked up. Meanwhile, both central banks are engaging in ‘quantitative tightening or QT’—not reinvesting all or most of the proceeds of their maturing securities—to help translate these rising policy rates into weaker financial conditions such as higher bond yields, lower equity prices and wider credit spreads. This is the mechanism that dampens economy-wide demand. 

As tightening continues, we look for full-year GDP growth to stall on both sides of the border. We see policy rates peaking in early 2023 at 4.5% for the BoC and the 5.00%-to-5.25% range for the Fed. And, we expect that central banks will remain on hold thereafter, assessing the impact of their rate hike efforts on inflation (though QT should continue in the background). We judge there’ll be enough progress made to forestall further rate hikes, but not enough to encourage rate cuts until early 2024. In both economies, we see key inflation measures running above 3% by the end of 2023, but on a clear track to 2%. 

However, the net risk is for policy rates to push further into the 5% range, which could trigger deeper downturns and rate cuts commencing in 2023. Given the uncertainty surrounding the depth and duration of any recession, it’s worth looking at the economy’s underlying tailwinds and headwinds.

As mentioned, the labour market is historically tight on both sides of the border, with demand far exceeding supply. Given the massive number of job openings, it’s hoped that weaker demand will largely be absorbed by these vacancies, and that significant job losses can be avoided. In other words, businesses are more likely to pull unfilled job postings before firing any existing workers. 

On top of consumers potentially staying employed, they also have a cache of ‘excess’ savings amassed since the pandemic’s onset to help support spending. Canadians’ saving rates are still above pre-pandemic norms even though they’ve stepped down from recent highs (i.e., 5.7% in Q3 vs. an average of 2.2% in 2015-19). Excess savings could be as high as C$350 billion, but some of this has probably become permanent savings or been used to pay down debt. In the U.S., the saving rate (2.4% in November) is below the 2015-19 average of 7.6%, so consumers have already started tapping their cache, which could still be as high as US$1.7 trillion.

Meanwhile, there’s still plenty of pent-up demand, especially for services—recall summertime travel delays and restaurant lineups. And, businesses will continue capital spending—fixed assets must be maintained, and outlays to alleviate labour shortages that are chronic in many cases are unlikely to subside substantially. 

But the economy does face some headwinds. As rates rise, heavily indebted consumers will feel the pain of mounting interest payments. That’s particularly concerning for Canada, where household debt is over 180% of disposable income. A clear example is in the housing market, which is already slumping from rising rates in both countries. This poses a particular vulnerability to Canada given the sector’s importance to the economy (a real GDP share of 6.6%, more than double America’s). All these factors could cause consumers to slow down their spending, especially if persistent inflation continues to chip away at their purchasing power.

Meantime, businesses, dealing with years of supply chain issues, have been shoring up inventories when they can. That’s been helping GDP growth. However, as demand wanes, that inventory buildup is becoming redundant, weighing on GDP. 

With the tailwinds partially offsetting the impending economic pain, our base projection includes only a short and shallow downturn in both Canada and the United States, with annual growth flat in 2023. But that doesn’t mean that consumers and businesses won’t feel the pinch. We’re already starting to see signs of growth slowing as inflation erodes purchasing power and higher interest rates weigh. And, while we expect the unemployment rate to rise further, the climb could be sharper if businesses do start to noticeably trim their payrolls. Meanwhile, central bankers will do everything in their power to curb inflation while inflicting as little pain as possible, a balance that’s becoming harder to hold.

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Michael Gregory, CFA Managing Director, Deputy Chief Economist and Head of U.S. Economics

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