The U.S. labour market has kicked into higher gear, with the unemployment rate falling to a cycle low of 5.8% in May. While payrolls are still down 7.6 million since the pandemic began (or -5.0%), 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 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 return close to pre-virus levels of 3.5% by 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 at a decade high. Lumber prices have quadrupled in the past year, while copper is at all-time highs, and wheat and corn prices are also on a roll, flagging higher food costs ahead. Along with semiconductor and other parts shortages, many factories can't find skilled workers. And now wages are starting to boil, 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, and the risks are likely still on the high side, especially 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 subside as the pandemic eases, and more persistent pressures will be held in check by long-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.
The 10-year Treasury rate has surprisingly dipped to a three-month low of 1.5% recently after spiking more than 60 bps this year, supported by QE. But we 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.
After showing surprising resilience to the second wave of the virus and new restrictions in the winter, Canada's economic growth is set to stall in the second quarter in response to the latest round of constraints to arrest a third wave of caseloads. However, hearty 5.6% annual growth in Q1 (led by booming residential construction) has real GDP now less than 2% short of pre-pandemic levels, with the balance likely to be recovered by 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 has kicked into high gear. Many businesses have adapted to restrictions and the economy has already proven that when it even partially re-opens, demand comes 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. Moreover, 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 20% y/y and many rural regions and smaller cities seeing gains in excess of 30%. A somewhat tougher mortgage stress test that took effect June 1 will have only a modest slowing effect on sales, likely merely pushing demand more 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 says there are 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.
A fierce rally in commodity prices is also lifting the economy by pulling the current account into surplus for the first time since 2008. While oil prices have risen somewhat above pre-virus levels and a bit higher than long-term norms in real terms, most of the other key resources that Canada sells abroad are even more buoyant. The Bank of Canada's ex-energy commodity price index has shot up nearly 30% in the past six months to all-time highs.
Surging commodities, along with a more hawkish turn by the central bank, has pumped the Canadian dollar to six-year highs above 82 cents US. The loonie is the top-performing currency this year (not counting the crypto kind). Resource prices are expected to ease moderately as more supply comes online and as consumer spending is diverted toward the service sector. Still, prices should remain supportive, and with the Bank of Canada likely to raise rates a little before the Fed, the loonie looks to have found its groove. 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 the slack could be absorbed in the second half of 2022 rather than in 2023. 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 2.1%, look to rise moderately further. But, as in the U.S., the risks are on the upside, suggesting a further tapering of asset purchases could arrive before the fall.