North American Outlook

June 05, 2024 | 12:45

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

Renewed inflation heat is making Powell and Co. sweat again, delaying rate cuts likely to September
A much cooler price climate in Canada spurred the first BoC rate cut in four years in June with more on the way
2024 started with slower U.S. growth but a pickup in Canada, though the latter has faded

United States

Inflation is finally showing signs of calming after a frothy start to the year. After rising 2.0% annualized in the second half of 2023, and thus meeting the Fed's definition of price stability, the core PCE deflator bolted 3.6% higher in the first quarter of 2024. The culprit is steamy services prices, in sharp contrast with deflating goods prices. 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 also proving a stubborn beast to tame, though recent market measures flag a deceleration. But core prices finally cooled somewhat in April, though the yearly rise remains stuck at 2.8% y/y, a bit hot for the Fed’s comfort.

The job market will need to loosen to cool wage growth and services prices. And it has, but only a little. Fewer businesses have job openings, fewer workers are quitting, and fewer consumers think jobs are plentiful. After a blowout quarter, payroll gains decelerated to a normal 175,000 in April. At 3.9%, the unemployment rate is half a percentage point above the cycle low. But it may need to rise further to take the edge off wage gains as employment costs and hourly compensation are still running north of 4% on a yearly basis.

For labour markets to loosen further, the economy will need to land at least softly; that is, grow at a sub-potential rate of under 2%. It did take a run at the tarmac in Q1, as real GDP slowed to a 1.3% annualized rate. Faster imports, slower inventory building, and a rare downshift in government spending led to a sharp drop in altitude from 3.4% in Q4 and 4.9% in Q3. Even consumer spending slowed to a 2.0% pace, and actually dipped in April to start Q2. Along with slowing payrolls, retail sales and industrial production both stalled in the month. 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 bear down on demand. A moderate pickup to 2.0% is expected in 2025 if the Fed reverses course, as we expect.

Inflation's wrong turn at the start of the year is likely a speed bump for rate cuts rather than a roadblock. Citing a "lack of further progress" on inflation, the FOMC provided no guidance on rate-cut timing after its May 1 policy meeting. Chair Powell said the committee will need some combination of calmer core prints and weaker labour markets to gain confidence in the inflation outlook. Throwing markets a bone, he at least said increases were "unlikely" as policy is already "sufficiently restrictive". We pushed out our call for the first reduction to September (from July) and expect just one follow-up move this year in December. If inflation behaves, though, an additional 175 bps of rate relief could flow by early 2027.

At least the FOMC is relaxing quantitative tightening. Starting 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 may ease pressure on Treasury yields, though what's really needed is much calmer inflation. The key message from the economic data and solid financial markets so far this year to the Fed is: There's no rush to cut rates.

Canada

The inflation embers have cooled more in Canada than in the U.S. due to weaker demand and looser labour markets. The Bank of Canada's preferred Median and Trim measures of core inflation decelerated to annual rates below 1.5% in the first four months of the year, the slowest since 2020 and below the target. Despite a soggy loonie, goods prices are up just 1% from a year ago. Services prices are still running fast at above 4%, largely due to two remaining white coals—rent and mortgage service costs. But this rate is down from the cycle high of almost 6%. Helping dampen inflation is a steadily rising jobless rate, now at 6.1% in April after sliding to a half-century low of 4.8% in 2022. A further increase to 6.6% later this year should slow unit labour costs that are still running hot at 4.3% y/y in Q1. Labour productivity is down 0.9% in the past year, providing no help in the inflation battle.

With overall inflation cooling considerably, recession risks have ebbed, although growth is still challenged. Real GDP grew a modest 1.7% annualized in Q1 after virtually stalling in the previous three quarters. 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, a solid rebound in employment in April, and steadier housing markets suggest growth will be about 1.5% in Q2. For all of 2024, growth could perk 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 continued expansionary fiscal policies at both the federal and provincial levels.

Economic growth of just 0.5% in the past year and a surging labour force have lifted the unemployment rate one percentage point to 6.1% in April. However, a return to above-potential growth next year should pull the jobless rate back below 6%. The decline will be greased by a slowdown in the population. The federal government plans to notably reduce the number of non-permanent residents in the next three years. Torrid growth in this segment drove the population to its largest increase in more than six decades last year (3.2%, or 1.3 million). 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 far 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. The Bank 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 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 clearly in play if the next two CPI and job reports are subdued, we lean toward September. Thereafter, rate cuts roughly every other meeting are expected well into 2025, with additional cuts 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 economic growth next year.