The Wait Is Almost Over

The anticipation is getting palpable. I’m not referring to the “will he or won’t he drop out of the race” bets in Washington and on online prediction markets, though I can’t help but share that PredictIt’s latest numbers show a rapidly dwindling chance that Joe Biden will win the 2024 Presidential Election (22%) and steady increase in Donald Trump’s chances (60%) since the first debate fallout two weeks ago (Chart 1). The sharp move in these implied probabilities and political spinning is enough to inject a lot of uncertainty into an election year that, so far, has been as exciting to watch as paint drying.

No, what I am talking about is that after a full year of waiting on the sidelines with a highly restrictive stance, Fed Chair Jay Powell and the FOMC are seriously contemplating cutting interest rates. Powell, in his Humphrey-Hawkins testimony to Congress this week, implied that the Fed isn’t as single-mindedly focused on their inflation mandate these days and now has one eye also trained on recent U.S. labor market cooling. Wait too long to cut interest rates and you risk outright recession and significant job losses, but move too early and the Fed risks reigniting another round of demand-driven inflation and financial market exuberance.

He noted in his testimony that we have seen considerable labor market cooling in the latest data, and that the Fed is very much aware of “two-sided” risks now. While he repeated that the Fed needs to see more “good inflation data” to boost its confidence for a rate cut, he also offered that if the labor market weakens unexpectedly, that could also be a case for a rate cut. The June employment report clearly caught Powell’s attention. The steady rise in the unemployment rate to 4.1% has nearly triggered the Sahm Rule, a historically reliable indicator, invented by economist Claudia Sahm, that signals when the economy has entered a recession. The rule states that any time the three-month moving average of the U.S. unemployment rate rises more than 0.5 percentage points from its lowest point over the last twelve months, the U.S. economy has already entered a recession. That number rose to 0.43 in June from 0.20 back in January and around zero in early 2023 (Chart 2). If in July, the unemployment rate rises by just another tenth of a percentage point to 4.2%, the Sahm Rule will be triggered at 0.50. True, it’s only one recession indicator, but it has a very good track record and it would join others, such as the inverted Treasury yield curve and the Conference Board’s Leading Economic Index, that point in a similar direction. In short, the foundations of the Goldilocks soft-landing narrative with record-high stock prices could be more fragile than the consensus expects.

As Powell is fond of mentioning these days, the timing of a rate cut will depend on the data. The June CPI report clearly qualifies as “good inflation data” in our eyes, and probably qualifies as 'great inflation' data in many FOMC participants’ eyes. The Fed funds futures market seems to agree, now fully pricing in a quarter-point rate cut at the September FOMC meeting, in-line with our long-held view, and between two and three quarter-point rate cuts by the end of the year (Chart 3). In short, the “two-sided” risks the Fed has been wrestling with and which kept it on the sidelines appear to be rapidly morphing into a one-sided risk of increasing labor market slack and decreasing inflation. The case for Fed rate cuts has strengthened tremendously since the June FOMC meeting with the latest CPI and employment reports Exhibit A.

Inflation: Perceptible Progress

There is no shortage of superlatives to describe the June CPI report. The stellar details include the first monthly headline drop since the 2020 shutdowns, the tamest core rise (0.06%) since January 2021, a fourth straight decline in core goods prices, a subdued shelter print (finally), and a second straight decrease in ‘supercore’ services prices. Moreover, the softness was widespread, including a fourth straight dive in airfares, a further decline in car prices, and tepid moves in medical care, clothing and recreation. Simply put, inflation took a holiday in June after winding down in May and working overtime earlier this year.

But which is the anomaly—the latest two months whereby the core index rose just 1.4% annualized, or the preceding four when it bounced 4.3%? Most likely the truth lies near the middle (tucked under 3%). However, there is some reason to believe the latest performance is more trend than noise. First, seasonal adjustment may not be adequately accounting for businesses hiking prices after the holiday season rather than the usual discounting. Similar price blips occurred at the start of the previous two years. Second, the milder inflation prints correlate with a recent slowing in economic growth and spending. PepsiCo noted this week that shoppers “have become more price conscious”. Third, lower inflation aligns with a looser labor market, as the jobless rate no longer sports a 3-handle. And fourth, the spike in core prices earlier this year didn’t derail disinflation. As shown in the chart, the 12-month average of monthly core price changes (0.27%) in June is half the peak (0.54%) reached in September 2022, and more than two-thirds of the way back to price stability (0.17%).

A word of caution, though. The June CPI likely overstates actual progress on inflation. A 5% dive in airfares trimmed 0.04% off the headline rate, while a 1.5% slide in used vehicle prices cut 0.03%, and both look to have shaved a tenth from the core increase. Two alternative CPI measures, compiled by the Cleveland Fed to control outlier effects, show more normal increases, with the trimmed-mean index up 0.17% and the weighted-median metric up 0.19%. Moreover, producer price pressures are warming up, with the core index popping 0.4% in June, kicking the yearly rate to 3.0%. Clearly, more inflation data are needed to gain confidence in the outlook.

The next release of the Fed’s preferred measure of inflation, PCE prices, is due later this month. Based on the details of the CPI and PPI reports, headline PCE prices look to fall slightly after holding steady in May, carving three tenths from the yearly rate to 2.3%. Core PCE prices likely held steady, a very rare event outside of recessions and shutdowns, slicing two tenths from the annual rise to 2.4%. The road back to price stability may be bumpy but it’s still heading in one direction.

U.S.-Canada Trade Tallies and Tussles

On June 14, the final edge girders connecting the two sides of the deck of the Gordie Howe International Bridge were put in place. The six-lane bridge connecting Detroit and Windsor is scheduled to open in the autumn of 2025, seven years after construction began. Currently, the (four-lane) Ambassador Bridge accommodates about one-quarter of the value of merchandise trade between the United States and Canada. The Gordie Howe Bridge will expand both capacity and efficiency (with direct connections to interstate and provincial highways), thus facilitating future growth in cross-border trade and travel. This event serves as a backdrop for our discussion on current U.S.-Canada trade trends along with the tiffs that inevitably arise.

Two-way trade in goods and services between the U.S. and Canada totaled $920 billion in the year ended 2024Q1 (Chart 1), meaning an average of $2.5 billion is crossing the border every single day. (In this report, we employ U.S. data denominated in U.S. dollars.) However, the distinction of being the world’s largest bilateral trading relationship is being tested. Two-way trade between the U.S. and Mexico totaled $905 billion in the latest period, seemingly headed to surpass Canada sometime this year. In a testament to the success of the USMCA and its NAFTA predecessor in promoting regional trade, North America boasts the globe’s largest and second-largest bilateral trading relationships.

Also, in recent years, both Canada and Mexico (but mostly Mexico) have benefited from the diversion of U.S. trade away from China. The trade war with China that escalated under the Trump Administration and continued under Biden’s has combined with the post-pandemic drive for supply chain resiliency to disrupt America’s prior trading patterns. Unbridled globalization is giving way to re-shoring, near-shoring, and friend-shoring, a boon for both Canada and Mexico (but, again, mostly Mexico) in the well-integrated North American economy.

Although Canada and Mexico have comparable total U.S. trade amounts, transactions with Canada generated a net trade deficit of $38 billion in the past year, far smaller than Mexico’s $167 billion. The latter is the largest it has ever been (partly mirroring a shrinking trade shortfall with China, which is raising eyebrows in Washington). U.S. net trade with Canada has deteriorated from its roughly balanced pre-pandemic position, but the current deficit is still well below what it has been historically, for example, before the Great Recession and Global Financial Crisis.

Digging further into the Canadian figures, two-way trade in goods amounted to almost $780 billion in the year ended 2024Q1, with trade in services totaling just above $140 billion (Chart 2). The former results in a goods trade deficit of just over $70 billion with the latter resulting in a services trade surplus of $32 billion. And the goods trade shortfall is very lopsided when viewed from a sectoral perspective.

Table 1 shows the balance of U.S.-Canada trade across the major (NAICS) sectors. Based on these industry data, two-way trade in goods totaled just over $770 billion in the year ended May 2024, resulting in a $63 billion deficit. (Note that these data are on a Census basis compared to the previously mentioned figures on a balance of payments basis, which accounts for the discrepancy, along with timing.)

Canada is America’s largest source of petroleum and crude oil imports, which is reflected in the $92 billion trade deficit in the oil and gas sector (in turn, fueled by higher crude oil prices). In the past year, the U.S. sported a $30 billion goods trade surplus with Canada excluding oil and gas, which incorporates an even larger $35 billion surplus in manufacturing. The U.S. has been running a manufacturing surplus with Canada steadily since 2008.

Within the manufacturing sector, the individual industry trade balances run on both sides of the ledger, from a $19 billion surplus for computers and electronic products to an $18 billion deficit for primary metals. (Of course, the latter is occurring under the watchful eye of the May 2019 agreement that removed the Section 232 tariffs on steel and aluminum along with Canada’s retaliatory tariffs.) Finally, indicative of the highly integrated nature of the U.S. and Canadian factory sectors, one of largest net deficit items is re-imports of goods previously exported to Canada, mostly as part of the overall manufacturing process.

Despite total trade resulting in an overall U.S. surplus outside of the oil and gas sector, this doesn’t prevent the odd trade wrangle. Earlier this year, amid the third USMCA mid-year meeting, U.S. officials raised three specific concerns: the digital services tax, dairy, and Quebec’s Bill 96.

Digital services tax (DST): Canada’s 3% levy on digital services revenues came into effect on June 28, 2024, retroactive to January 2022. Canada is not alone in enacting or proposing a DST; an October 2023 Bipartisan Policy Centre report tallied 38 countries in this camp. The United States Trade Representative (USTR) had previously investigated the enacted/proposed DSTs of other countries and concluded that they were discriminatory toward U.S. firms and announced retaliatory tariffs. However, the USTR suspended the tariffs and further ‘Section 301’ investigations after the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) was announced in October 2021. Countries having enacted a DST could continue to tax and not face a retaliatory tariff if they agreed to stop their DSTs once an international DST deal was done. The deadline for the latter was June 30, 2024, with most framework members agreeing to push back the deadline by at least a year and not impose their own new DST in the interim. Canada was one of the handful of framework members (among 145) to not agree, citing the absence of a new hard deadline for a deal while other countries (such as the UK and France) continue to collect on their existing DSTs. Last month, the USTR office said it’s “assessing” the situation and “open to using, all available tools that could result in meaningful progress toward addressing unilateral, discriminatory DSTs”.

Dairy: Canada’s system of supply management (for dairy, poultry, and eggs) aims to stabilize prices and producer returns by limiting domestic production and tightly restricting imports. Under the USMCA, Canada committed to providing the U.S. greater access to its market in all three areas, particularly for dairy (tariff-free quota equivalent to roughly 3.5% of Canadian consumption). However, since the USMCA took effect, U.S. producers have repeatedly taken issue with the manner in which Canada has implemented its market access commitments. They have argued that by allocating quota only to domestic dairy processors and distributors, and not to retailers, Canada has prioritized imports of lower-value dairy ingredients rather than finished consumer products. In November 2023, a USMCA panel sided with Canada after an initial panel in December 2021 sided with the U.S. (the latter caused Canada to tweak its quota allocation process). Unlike other Canadian trade agreements, including CETA (with the European Union) and the CPTPP (with various Pacific Rim countries), the text of the USMCA did not specifically guarantee that retailers would be allocated tariff-free quota.

Quebec’s Bill 96: Passed by the provincial legislature in June 2022, the law makes the province’s French language law more stringent. Draft regulations were released in January 2024. U.S. officials are specifically concerned about the provisions affecting trademarks. According to The Globe and Mail, since November 2022, “U.S. officials have discussed in private whether the restrictions in Bill 96 constitute a technical barrier to trade, a breach of trade-related intellectual property rights or a violation of Section 301 of the Trade Act of 1974, and whether those breaches would justify trade sanctions.”

Other U.S.-Canada trade irritants that are currently on the radar include:

Online Streaming Act: This was enacted April 2023 and gives power to the Canadian Radio-Television and Telecommunications Commission (CRTC) to regulate digital platforms that broadcast audio and video. The CRTC will require large online streaming services (not affiliated with a Canadian broadcaster) to contribute 5% of their revenues to certain funds that promote domestic production. Also, Canadian content rules will also eventually be imposed. The Motion Picture Association Canada (on behalf of Netflix, Walt Disney, Warner Bros Discovery, and Paramount Global) have challenged this in court. Meanwhile, 19 members of Congress have petitioned the USTR to investigate.

Online News Act: This was enacted June 2023 and creates a bargaining framework to ensure that digital platforms compensate news businesses when their content is made available on their services. If voluntary commercial agreements can’t be reached, ones will be mediated or arbitrated. Some members of Congress have petitioned the USTR to investigate, as others have introduced similar legislation for the U.S. Meanwhile, Meta (Facebook and Instagram) has ended access to Canadian news on its platforms, but Google reached an agreement.

‘Rules of origin’ in the automotive sector: Under the USMCA, the U.S. was arguing for a stricter method for calculating the 75% regional value content (RVC) for final products and their core parts. Canada and Mexico argued the RVC as agreed to was less strict and a USMCA panel ruled in their favor in December 2022. North American content requirements became an issue again with the Inflation Reduction Act and its support for U.S. EV and battery production.

America’s trade imbalances broadly, or in individual industries specifically, are hot political topics. This has been the case during both the Trump and Biden administrations, with the former having taken a particularly hard line on trade issues. Despite total trade with Canada resulting in an overall U.S. surplus outside of the oil and gas sector, with U.S. elections approaching and 2026’s review of the USMCA on the docket for the next Administration and Congress (regardless of who, or which party, wins), the above U.S.-Canada trade irritants and others simmering on the backburner could become increasingly problematic.

— with files from Aaron Goertzen