North American Outlook

July 02, 2021 | 13:15

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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

The U.S. economy is reaping big dividends from its speedy vaccine rollout and fiscal stimulus, with the economy accelerating in the first half of the year and on track for 6.8% growth in 2021, the most since 1984.

Canada will soon follow its biggest trading partner. While renewed lockdowns likely stalled growth in the spring, a peppy start to the year and a sharp rebound as businesses reopen should keep it on track for 6.0% in 2021, the most in about half a century.

Stimulus and vaccines are causing U.S. demand to rebound much faster than supply, creating many side-effects, notably rising inflation, early in the recovery.

The Bank of Canada has shifted policy gears by tapering asset purchases. While both it and the Fed may wait until early 2023 to raise rates, hefty fiscal stimulus and brewing inflation could advance the timing.

United States

A rapidly reopening U.S. economy is quickly making up lost ground. Real GDP jumped 6.4% annualized in the first quarter and will surpass pre-pandemic levels in the current quarter. Consumer spending rocketed 11.4%, as newly-vaccinated shoppers unleashed a torrent of pent-up demand for dining, travel, and just about everything else amid two more rapid-fire rounds of stimulus payments. Households are far from exhausted, having piled up sufficient aggregate savings in the past year (over $2.2 trillion) to sustain strong spending even if a good portion is used for debt repayment and investing. The rebate payments, extra UI payouts, and rising employment contributed to a record 60% (annualized) jump in personal income in Q1. Nonresidential business spending rose about 12%, despite lingering weakness in commercial construction. Even with a mid-quarter snowstorm and regional blackouts, residential construction posted another double-digit gain, with housing starts and new home sales both hitting 15-year highs at quarter end. The two major headwinds in Q1 were plunging business inventories and a record trade deficit. The former was partly due to a logjam at California ports and chip shortages that led to temporary auto plant closures. The latter reflected strong domestic demand, a contracting Euro Area economy, and a still-high-valued greenback.
The monthly economic releases and timelier data on retail mobility, indoor dining, hotel stays and air passengers suggest the economy's momentum carried into the second quarter. While consumers took a breather in the spring, business investment looks to have sped up, based on strong capital goods orders and shipments. ISM services rose to record highs in May, while the factory index hit its second highest level since 1984. Nonfarm payrolls accelerated in June, though new auto sales have spun in reverse since April's 15-year high due to model shortages. We expect real GDP to grow 9.5% annualized in Q2, around 8% in Q3, and 6.8% in 2021.
The recovery was juiced by the $1.9 trillion American Rescue Plan Act, which was passed in early March and featured $1,400 in rebate payments to most households and a six-month extension of the emergency UI programs. Households will get an extra jolt from the expanded child tax credit that will be sent out monthly starting in mid-July to year-end. The President has proposed about $1 trillion for the American Jobs Plan (scaled back from $2.3 trillion initially to make it more palatable for Republicans), focused on infrastructure spending, and $1.8 trillion for the American Families Plan, aimed at childcare and education. However, both plans will likely be slimmed down in Congress (the House recently passed a smaller $715 billion infrastructure plan) and, in any event, the spending measures will be spread over many years and mostly offset by higher taxes, possibly on corporations and top-income earners. Still, fiscal policy will likely continue to provide a net boost to the economy in the next two years. The tradeoff is a larger-than-expected budget deficit, which looks to exceed 6% of GDP next fiscal year, small only when compared with this year's near 16% shortfall.

The U.S. labour market has kicked into higher gear, with the unemployment rate at 5.9% in June. While payrolls are still down 6.8 million since the pandemic began (or -4.4%), that's a big improvement from the initial 22 million loss during the shutdowns. Rather than weak demand, it's the supply side that appears to be holding back hiring, even for lower-skilled jobs in some hard-hit industries such as restaurants. Many companies are having trouble calling back workers or filling new positions, citing a lack of qualifications, virus fears, child-care duties, and expanded UI benefits. The participation rate is still 1.7 ppts below pre-pandemic levels, though it should rise as more people are vaccinated, thus supporting job growth and allaying wage pressures. A rising participation rate will also slow the jobless rate's descent, though it should slip below 4% in late 2022.
We have also revised up our inflation call. Inflation pressures are percolating in response to massive policy stimulus, surging money growth, booming resource prices, and supply-chain disruptions. The CRB commodity price index is near a decade high, as a partial retreat in previously surging lumber and metal prices has been offset by a further climb in oil and natural gas. Along with semiconductor and other parts shortages, many factories can't find skilled workers. And now wages are starting to simmer, with unit labour costs trending at the fastest rate in nearly four decades. As more states and countries fully reopen for business, some of the supply-chain bottlenecks will ebb. But worker shortages, which normally don’t show up until well into an economic boom rather than in the first year, could worsen if the participation rate doesn’t keep up with hiring. Consequently, more companies are saying they will try to pass higher input costs onto consumers. If enough firms do so, this could sustain inflation at much higher levels, especially if workers demand higher wages as compensation. The headline CPI rate has rocketed to 5.0% in May, the highest since 2008, while the core measure has more than doubled to 3.8%, the most since 1992. Only part of the increase reflects low base-year effects, as the 2-year annualized core rate is running at 2.5%, a more than 13-year high. Broad price pressures are stirring beneath the surface, while the previously-hammered travel industry is seeing a sharp reversal in declines amid strong pent-up demand for flights, hotels and auto rentals. We expect CPI inflation to average nearly 4% this year and above 3% next year, with upside risk if policymakers keep pressing on the gas and the economy's engine overheats. For now, we suspect some near-term price pressures, such as supply-chain bottlenecks, will ebb as the pandemic eases, and more persistent pressures will be held in check by longer-run forces such as automation, globalization and an aging population.
Core PCE inflation, the Fed's preferred guide, is expected to average around 3% this year and next. That's likely at the upper end of the Fed's tolerance range, as it aims to sustain inflation moderately above the 2% target for some time to compensate for a decade of undershooting. The Fed's new framework also takes a much less pre-emptive approach to responding to inflation and puts more weight on achieving a so-called inclusive recovery, where the hardest-hit workers in the pandemic regain employment. We currently expect policy rates to stay near zero until March 2023, but the risk is toward an earlier move if inflation stays on the high side. As well, amidst growing chatter of a taper discussion at upcoming policy meetings, we expect the FOMC to begin reducing its asset purchases (currently $120 billion per month) in the final quarter of this year, at least easing up on the accelerator.
Supported by the Fed's purchases, as well as concerns about the Delta variant and the supply-side brake on growth, the 10-year Treasury rate has dipped to a three-month low below 1.5% after spiking more than 60 bps this year. We still see it trending modestly higher to 1.75% by year-end and to 2.00% by late next year in response to Fed tapering, strong growth, higher inflation, and a hefty budget deficit.

Canada

After showing surprising resilience to the second wave of the virus and new restrictions in the winter, Canada's economic growth looks to slow to around 2.5% annualized in Q2 in response to the latest round of constraints to arrest a third wave of caseloads. Industry GDP contracted in April and likely in May as well. However, hearty 5.6% growth in Q1 (led by booming residential construction) has real GDP now less than 2% shy of pre-pandemic levels, with the balance likely to be recovered in Q3, just one quarter behind the U.S. recovery. The same forces pushing the U.S. economy faster—massive fiscal stimulus, pent-up demand, hefty household savings—are set to drive Canadian GDP skyward in the second half of the year, especially now that the vaccine rollout and reopenings have kicked into high gear. Many businesses have adapted to restrictions and the economy has already proven that when it even partially reopens, demand will come roaring back fast. Canada could have four-fifths of its population aged 12 and older fully vaccinated by the end of August, close to the threshold for broad immunity. The commodity rally has also lifted the economy by pulling the current account into surplus for the first time since 2008. The federal budget announced another $101 billion of new spending over three years, half of which will arrive this year, amounting to 2% of GDP.
Meantime, home sales have cooled only marginally from record levels in March, with benchmark home prices clocking in at 24% y/y and many rural regions and smaller cities seeing gains in excess of 40%. A somewhat tougher mortgage stress test that took effect June 1 will have only a modest slowing effect on sales, likely merely pushing demand toward the lower-end of the market. Still, eroding affordability will clamp down on activity, allowing price gains to cool somewhat, hopefully before a correction becomes inevitable (the Bank of Canada sees extrapolative price expectations in some regions). Overall, Canada's GDP is expected to grow 6.0% in 2021 and 4.5% in 2022, a hearty rebound from last year's 5.3% contraction.
While the Canadian dollar has pulled back recently from six-year highs, supportive commodity prices and a central bank that is likely to lift policy rates a little before the Fed should keep the loonie on a rising flight path. We see it cruising above 83 cents at year-end and to around 85 cents (C$1.175) by late 2022, partly on the back of a softer greenback as safe-haven demand ebbs further.
The Bank of Canada has started to reduce the pace of government bond purchases to $3 billion per week from at least $4 billion. It expects a strong economic rebound and now believes slack could be absorbed in the second half of 2022. However, the Bank also remains wary of pandemic-related risks and remains "committed to holding the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved." We see it starting rate lift-off in January 2023. Like the Fed, the Bank is willing to tolerate some upward drift in inflation, as its 1%-to-3% target range affords flexibility. The three core measures of inflation, currently averaging an 11-year high of 2.3%, look to rise moderately further, suggesting a further tapering could arrive before the fall.