North American Outlook

June 28, 2024 | 15:06

Sticky Inflation, Sticky Rates

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Key Summary

2024 started with slower U.S. growth but a much-welcomed pickup in Canada
Slower growth and some recent cooling in inflation open the door for a Fed rate cut this September
A cooler price climate in Canada spurred the first Bank of Canada rate cut in four years in June, but a hotter May CPI report suggests the easing cycle will be gradual

United States

After a heated start to the year, inflation is showing signs of cooling again. The core PCE deflator bolted 3.7% (annualized) in the first quarter after rising just 2.0% in each of the prior two quarters. The culprit was steamy services prices, in sharp contrast with deflating goods. Sturdy gains in necessities such as auto insurance, electricity and natural gas piled onto strength in discretionary items such as recreational services and hotel fees. Rent is proving a stubborn beast to tame, though recent market-based measures flag a deceleration. Thankfully, core prices cooled in May, cutting the yearly rate to just 2.6%, the lowest in over three years. And the cooling was largely in services prices.

A loosening labour market is helping to subdue inflation. Fewer businesses have job openings, fewer workers are quitting, and fewer consumers think jobs are plentiful. At 4.0%, the unemployment rate is up from a cycle-low 3.4%. However, it may need to rise modestly further to reduce employment costs that are still running north of 4% y/y.

Labour markets are loosening because the economy has decelerated to a sub-potential rate of under 2%. Real GDP slowed to a 1.4% annualized rate in Q1 from 3.4% in Q4 on slower consumer and government spending and a rising trade deficit. Personal spending also remained subdued in the first two months of Q2. For all of 2024, GDP growth looks to decelerate to 1.4% on a Q4/Q4 basis, a little less than half of last year's rate, as elevated interest rates are bearing down on demand. A modest pickup to 2.0% is expected in 2025 as the Fed reverses gears.

Though citing "modest further progress" on inflation, the FOMC provided no clear guidance on rate-cut timing after its June meeting. Clearly, there is little rush to ease policy, even if it is deemed highly restrictive. Chair Powell said the committee will need a combination of data showing calmer core prices, labour markets, and economic growth before gaining confidence in the inflation outlook. Should recent softer trends persist this summer, the Fed should be on course to reduce rates by 25 bps in September. And, if inflation continues to ebb, an additional 200 bps of rate relief could flow by early 2027.

The FOMC is also relaxing quantitative tightening. As of June 1, it began reinvesting all but $25 billion of maturing Treasury notes per month, down from the previous cap of $60 billion. The slower-than-expected run-off of its bond portfolio, coupled with moderating inflation, should ease pressure on Treasury yields. Still, given a ballooning budget deficit of almost $2 trillion this year (or 6.7% of GDP) according to the Congressional Budget Office, bond yields are likely to remain well above pre-pandemic levels. We see the 10-year yield retaining a 4-handle even at the end of next year.

Canada

The inflation embers have cooled more in Canada than in the U.S. due to weaker demand and looser labour markets, but rents and other services prices remain an issue. Yearly CPI inflation was 2.9% in May, down from a cycle-high 8.1% in mid-2022. The Bank of Canada's preferred Median and Trim measures of core inflation have decelerated with their yearly rates also tucked under 3%. Despite a soggy loonie, goods prices are up just 1% from a year ago. But services prices are still running hot at 4.6%, largely due to two remaining white coals—rent and mortgage service costs. In fact, rents have soared 8.9% y/y, the most in over four decades. Still, we expect inflation to trend back to the 2% target over the next year amid a rising jobless rate, now at 6.2% in May compared with a half-century low of 4.8% in 2022. An expected further increase to 6.6% later this year should slow unit labour costs that are still running hard at 4.3% y/y in Q1. Labour productivity is down 0.9% in the past year, proving to be no ally in the inflation battle.

Recession risks have ebbed, but growth remains challenged. Real GDP grew a modest 1.7% annualized in Q1 after virtually stalling in the second half of last year. The upturn was led by solid 3.0% growth in consumer spending amid a mild winter and some rebound in business investment. While momentum faded late in the quarter, the early read on Q2 is for growth to remain close to the Q1 pace. Perkier auto sales amid strong job gains suggest consumers still have something left in the tank despite resetting mortgage payments. However, housing markets in the affordability-challenged provinces of Ontario and British Columbia remain quiet, with gains concentrated in the less-expensive Prairie Provinces and Atlantic Canada, where prices continue to rise. For all of 2024, real GDP growth could firm up to 1.7% on a Q4/Q4 basis from 1.0% last year, before stepping up further to 2.1% in 2025 on the back of easier monetary policy and expansionary fiscal policies at both the federal and provincial levels.

Economic growth of just 1.1% in the past year to April and a surging labour force have lifted the unemployment rate to more than two-year highs, but a return to above-potential growth in 2025 should pull it back below 6%. The decline will be greased by slower population growth. The federal government plans to materially reduce the number of non-permanent residents in the next three years. Torrid growth in this segment has driven the population to its largest annual increase in more than six decades (3.2% to Q2, or 1.3 million people). The planned cutbacks could see a return to more normal expansion of 1%, giving job creators and home builders a realistic chance of keeping up.

Just as the Bank of Canada led on the way up in 2022, it looks to lead on the way down for rate cuts, even if it can't run too much ahead of the Fed or the loonie will weaken heavily and fan inflation. As expected, the Bank lowered policy rates by 25 bps on June 5, the first decline in four years. It signaled that this is the first in a series of moves, as policy no longer needs to remain severely restrictive to achieve the inflation target given rising slack in the economy. The pace of rate cuts will be determined largely by further progress in lowering core inflation. While a July follow-up move is still in play, it will likely require a mild June CPI print after May's setback. For now, we lean toward a September move. Thereafter, rate cuts roughly every other meeting are expected well into 2025, with additional reductions through mid-2026 taking policy rates back to a more neutral level of 3.0%. That's still higher than at any time between the financial crisis and mid-2022, but will provide material relief for borrowers and set the stage for stronger growth next year.