North American Outlook
September 07, 2022 | 15:12
The U.S. economy contracted in the first half of the year and, like Canada, should see little to no growth in the year ahead, though both countries may avoid a painful recession if inflation subsides as expected.
Lower commodity prices, easing supply disruptions, and cooler demand suggest inflation may be peaking, though the climb down the mountain will likely be slow.
Central banks are committed to raising policy rates to at least moderately restrictive levels by year-end, and are unlikely to reverse gears to support the economy until 2024.
The U.S. and Canadian economies have quickly lost steam with the former actually contracting in the first half of the year. The drag from rapidly-rising prices and interest rates has outweighed the lift from higher wages and excess savings. In addition, the global economy continues to weaken, with Europe's energy crisis threatening to tip the continent into recession and China's pandemic lockdowns casting a pall over Asia. We have reduced our 2023 growth forecast by half a percentage point to just 0.5% in the U.S. and to 1.0% in Canada, staying below consensus. Both economies will likely contract in at least one quarter near the turn of the year. Our outlook might not qualify as an official recession, but it will feel like one for many businesses and some workers.
The growth downgrade reflects recent weaker data and tighter monetary policy. U.S. real GDP contracted 0.6% annualized in Q2 following a larger decline in the prior quarter. Weaker consumer spending, a surprising decline in business investment, and a cooling housing market indicated an even softer underbelly than in the first quarter, when the contraction was concentrated in inventories and exports.
Still, the U.S. economy is probably not in recession. In fact, recent data suggest real GDP will rebound at least modestly in Q3. Moreover, nearly 2.7 million payrolls were added in the first half of the year and more than 800,000 in July and August. The surge in hiring, despite recession talk and worker shortages, fully erased the 22 million jobs that were lost at the start of the pandemic. It also lowered the unemployment rate to 3.5% in July, matching the 53-year low set before the pandemic, though a surge in workforce participation kicked the rate up to 3.7% in August. We expect the jobless rate to rise to 4.6% as the economy struggles to grow in the year ahead.
Canada's economy is holding up better than the U.S. due to a delayed reopening bounce from the pandemic and earlier support from high commodity prices. Real GDP growth strengthened to 3.3% annualized in Q2 from 3.1% in the prior quarter. While the increase was less than anticipated, it was led by huge gains in consumer spending and business investment. More recent data, however, suggest activity is weakening. Employment has fallen this summer, reflecting both softer demand and worker shortages. The current4.9% unemployment rate is the lowest in five decades. Real GDP looks set to grow just 1.0% in the third quarter and stall at the turn of the year.
In both countries, the earlier mania gripping housing markets has fizzled fast, as rising mortgage rates have hammered already poor affordability. Sales have plunged to below pre-pandemic levels and look to stay soft this year. Prices have fallen for several months in Canada and are expected to tumble 20% by next spring, marking the steepest correction on record. The decline should take prices back to levels of spring 2021 and affordability to moderately above long-run norms from the worst levels since the 1989 bubble. By next summer, however, prices could resume rising amid record immigration and a tight rental market. U.S. resale prices rose through the spring due to low listings, pushing affordability to the worst levels since 1989. However, timelier data from Redfin suggest prices are now falling, likely the start of at least a 10% correction.
Central banks will need to press harder on the brake to suppress inflation. And, they likely will maintain a restrictive stance until inflation is headed convincingly toward the 2% target. After raising policy rates by 300 bps since March, the Bank of Canada says rates still "need to rise further". We look for one final 50-bp hike to 3.75% in October, before the Bank moves to the sidelines as the economy stalls and inflation falls. Given the expected gradual decline in inflation, the Bank is unlikely to begin reversing gears until early 2024, eventually returning policy rates to more neutral levels of around 2.25% in 2025. We have also marked up our call for the Fed funds rate by 25 bps in light of hawkish comments from officials, including Chair Powell saying that policymakers need to act "purposefully" to move the stance of policy to "sufficiently restrictive" levels. We expect a third straight 75-bp hike on September 21, followed by 50-bp and 25-bp moves in the final two months of the year, taking the funds rate target range up to 3.75%-4.00%. Like the Bank, the Fed is not expected to begin easing policy until early 2024. In both countries, we suspect that long-term bond yields are close to peaking given the weak growth outlook.
It all comes down to inflation, of course. For a change, not all the news has been bad. Commodity prices have reversed meaningfully, led by base metals, lumber, and crops. The Commodity Research Bureau's spot index is down 10% from April's high, nearly reversing the past year's gain. Oil prices have slid below $85 a barrel, though scorching temperatures have cranked up air conditioning and natural gas prices. Supply chain bottlenecks have eased a little amid shorter delivery times, fewer order backlogs, and less clogged ports. While scant inventories are still propelling new car prices higher in the U.S. and Canada, automakers aim to boost production as more microchips become available. Large retailers are now cutting prices to clear out unsold inventory ahead of the holiday-shopping season. Perhaps the best news is that most measures of long-term inflation expectations have eased a bit, giving central banks some breathing room. In addition, there is some evidence that U.S. companies are having a slightly easier time finding and retaining workers, possibly due to recession fears.
But inflation that stops rising is one thing; how quickly it retreats from four-decade highs is another. Here, prospects are less sanguine. Rising wages and rents due to tight labour and rental markets suggest persistence. Faster increases in services prices are offsetting slower goods prices. Consequently, current high CPI rates of 8.5% in the U.S. and 7.6% in Canada will likely still hover near 5% by the middle of next year and around 3% in late 2023. The latter are still well above the 2% inflation targets, meaning central bankers will need to bite their lip to avoid sending the economy into a tailspin.
A key question is: how much weakness in demand is required to restore price stability? In our view, and assuming some further retreat in commodities and lessening of supply chain pressures, it will take enough weakness to lift the jobless rate sufficiently to cool wages. The Fed believes the so-called neutral rate of unemployment is around 4.0%, though Powell suspects it may have risen due to a shift away from customer-facing jobs. In any case, the current jobless rate must exceed the neutral rate to slow wage growth and ease inflation pressure. While a recession is not a necessary condition for this to occur, a period of sustained weak demand is, as per our outlook.
Stubborn inflation continues to pose the single biggest threat to the economy. Inflation may not fall according to plan, let alone as fast as the consensus view, which is a full percentage point lower than our call in 2023. In this event, policy rates would need to be much more restrictive, well north of 4%. If so, there won't be much debate about whether the economy can avoid a deep downturn. As well, along with the potential for the war in Ukraine to escalate, heightened tensions between the U.S. and China are a concern.