North American Outlook

January 03, 2024 | 13:15

Take It Easier

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

It's looking increasingly likely that central bankers will pull off a rare soft landing after the greatest inflation scare in decades
Though it's too soon to claim mission accomplished, fading inflation should pave the way for easier monetary policies by the summer
While long-term rates won't return to former lows, the worst case threat of higher-for-longer has faded

United States: The Pivot

December 13, 2023 could go down as a seminal moment for investors and the economy. On that day, the Federal Open Market Committee all but shelved serious thoughts about raising policy rates further, while pencilling in three rate cuts in 2024, one more than previously expected. Moreover, given the opportunity to tone down investor hopes of 100 basis points of rate cuts this year, Chair Powell seemingly fanned aspirations by stating that a discussion on the easing timeline was beginning to come "into view". That's all investors needed to hear to tack on an additional 50 bps in cuts, starting in March. Heeding the old saw about not fighting the Fed, we too expect rate cuts to arrive sooner and faster this year than previously thought: 100 bps starting in July. However, we suspect an abundance of inflation caution could lead to a slower easing gait than the market expects.

The so-called 'Powell pivot' reflects four developments. The first is that policy risks are better balanced now that inflation is within reach of the target. Annual growth in the personal expenditures price index slid to 2.6% in November from 7.1% in mid-2022. And this is not just a story about cheaper fuel, as the core rate has fallen to 3.2% from a 5.6% cycle high, with shorter-term trends actually bracketing the 2% target. Durable goods prices have declined 2.1% in the past year (i.e., deflation), while increases in previously sticky services costs, including rents, are also moderating. We expect headline and core inflation to hover in the low 2s by year-end.

Second, the pivot in policy plans reflects a growing possibility that the inflation target could be attained even if the economy continues to grow at a healthy rate and the jobless rate stays low. Prior to December, Powell had consistently preached that a period of growth well below potential was needed to loosen the labour market and ease cost pressures. Yet, the core rate kept falling despite 4.9% annualized growth in real GDP in Q3. This suggests the earlier spike in inflation was indeed partly transitory, with easing supply disruptions and rising labour force participation now supporting a reversal. Improved productivity is also lending a hand. Despite a healthy 4.0% y/y increase in hourly compensation in Q3, growth in unit labour costs among nonfarm businesses slowed to a mild 1.6% rate owing to a 2.4% jump in productivity. The latter was the fastest in over two years, hinting at a possible payoff from increased use of AI technology.

Third, the pivot reflects the need to prevent real interest rates from rising as inflation ebbs. And, eventually, the Fed will need to turn the policy dial back to more neutral settings to prevent inflation from undershooting the target. This will involve reducing the fed funds rate from the current range of 5.25%-to-5.50% to 3% or less, though the reversal could take a couple of years to unfold.

Finally, the pivot acknowledges that real GDP growth likely slowed in Q4 and could remain soft for some time. Elevated interest rates, student loan repayments, dwindling excess savings, and fading fiscal stimulus could see growth downshift to 1.0% annualized in Q4 and average just 1.5% in 2024, compared with an estimated 2.4% in 2023. A near-5% y/y increase in real government spending to Q3 won't repeat this year. The federal budget deficit likely expanded by almost 1.5% of GDP in calendar 2023 (to nearly 7%), but it is expected to shrink by about 1% of GDP in 2024. Moreover, the torrid 63% y/y pace of construction spending on manufacturing facilities to November, largely due to federal incentives to spur production of semiconductors, electric batteries and clean energy products, is now moderating–though it should continue to provide support as less than half of announced spending plans have been undertaken to date. The downshift in economic growth should lift the unemployment rate from 3.7% in November to 4.3% this summer, which is still low historically and consistent with a soft landing.

An earlier timeline for Fed rate cuts lowers the odds of a recession, likely to below 40% this year. Furthermore, with 10-year Treasury yields sliding from 5% last fall to below 4%, high-yield corporate bond spreads plunging more than a percentage point in the past year, and the Dow index and home prices reaching new heights, financial conditions will provide modest support to the economy in 2024 after acting as a moderate brake last year.

Canada: The Divot

Unlike the U.S., 2023 was unkind to Canada's economy. Despite a pickup in its major trading partner and even stronger population growth, real GDP growth likely downshifted to 1.0% in 2023 from 3.4% in 2022. The economy contracted in the third quarter and, on a monthly basis, hasn't grown since the spring. Consumer spending was flat in Q3, while business investment and exports fell sharply. With no growth expected through the turn of the year, recession risks loom. Growth looks to decelerate further to just 0.5% in 2024; still qualifying as a soft landing, but barely.

How can an economy whose workforce grew more than 3% in the past year come to a virtual standstill? First, by producing less output per worker, with productivity dropping 2.5% in the year to Q3. Second, by racking up household debt faster than income in the past decade, mostly to buy houses at ever-inflated prices. Consequently, homeowners now need to divert more income to cover mortgage payments. A recent Bank of Canada study estimates that payments could rise about 34% by 2027, even if interest rates decline as the market expects; or jump 45% if rates stay high. Third, by not building enough new homes for a record 1.25 million new residents in the past year. This has led to the worst affordability in four decades, resulting in five straight monthly declines in existing home sales to November. And fourth, by posting no growth in non-residential investment in the past year, while seeing an outright decline in the number of active businesses as insolvencies top pre-pandemic levels. Against a backdrop of 3% population growth, activity is demonstrably worse in per capita terms; meaning that living standards are shrinking.

With growth on the rocks, the inflation tide is going out. Since peaking in mid-2022, the annual CPI rate has fallen five percentage points to 3.1%, with the major core metrics running only modestly higher. With the jobless rate up nearly one percentage point to 5.8% in November from half-century lows and expected to reach 6.5% this summer, inflation will likely continue to ease, despite ongoing pressure from rising mortgage payments and rents. We expect the CPI rate to dip below 2.5% by year-end.

So, why is the Bank of Canada still warning about possible rate hikes? The phrase "once burned, twice shy" comes to mind. After hinting at a pause in the tightening cycle in early 2023, the Bank was forced to renege after inflation proved stubborn and the housing market roared back to life. The Bank won't make that mistake again. Moreover, reversing course prematurely risks losing credibility if inflation stays above target. Still, with the economy teetering and inflation melting, further rate hikes are unlikely, and reductions should begin in June, taking the overnight rate from 5% currently to 4% by year-end and below 3% in early 2026.

Market expectations that the Fed will ease policy before the Bank have breathed new life into the moribund Canadian dollar, lifting it to 75 cents US for the first time in five months. But, given the weaker economic outlook and poorer productivity performance than the U.S., the loonie will likely make little headway this year, even as the greenback softens further on a trade-weighted basis.