North American Outlook

April 03, 2024 | 10:19

Still Airborne

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

Central bankers look to pull off a rare soft landing after the greatest inflation scare in decades
A sturdy U.S. economy may have pulled Canada back from the recession edge
Stubborn though fading inflation should pave the way for easier monetary policies this summer

United States

The U.S. economy keeps chugging along. Even after stellar 4.9% annualized growth in Q3, real GDP still rose 3.4% in Q4 on broad-based strength. Accordingly, we raised our 2024 call to 2.3%, implying just a modest deceleration from 2.5% growth last year. Instead of asking how hard the economy will land, the question now is whether it will even return to the tarmac. Growth risks are decidedly to the upside amid improved financial conditions and sturdy consumer spending. Record equity and home prices and falling interest rates suggest financial conditions will provide a modest tailwind for growth this year after acting as a gentle brake last year. Meantime, robust incomes, moderate debt burdens and rising confidence are keeping shoppers in fighting form.

Still, we expect the U.S. economy to slow somewhat as it fully digests the impact of past rate hikes. Moreover, the torrid pace of factory construction (juiced by federal incentives to spur production of semiconductors, electric batteries and clean energy products) is starting to moderate, although spending growth should remain positive as less than half of announced plans have begun. Also hindering growth will be student loan repayments, dwindling excess savings, and some deceleration in government spending. We look for GDP growth to downshift to 2.0% annualized in Q1 and further to 1.2% in Q2, before turning upward.

Slower growth should lift the unemployment rate moderately from 3.9% in February to 4.3% at year-end, while keeping it within a percentage point of the half-century low registered this cycle. However, apart from some recent softness in household-survey jobs, there's little hard evidence that labour markets are weakening. Nonfarm payroll gains have averaged 265,000 in the past three months, the fastest since last summer and well above long-run norms. Jobless claims remain low, job vacancies are still elevated (though down from record highs), and layoff announcements have mostly normalized after spiking early last year.

Despite the strong labour market, inflation pressures continue to ebb. The PCE deflator rose 2.5% y/y in February, well below the 2022 peak of 7.1%, while core prices are up 2.8%. Disinflation received a big assist from improved global supply chains and lower resource prices, which have pulled goods prices lower. Moreover, rising productivity has taken the sting out of still-brisk wage gains, reducing the temptation of business owners to boost prices. Unit labour costs increased 2.5% y/y in Q4, down from the four-decade high of 6.5% reached in early 2022. However, the inflation battle isn't over. Consecutive upward surprises in the CPI this year were driven by broad gains in services prices, including rent. Headline CPI inflation ticked up to 3.2% in February, while the core rate of 3.8% is running even faster on a shorter-term basis.

Given the progress on inflation, the FOMC is trying to determine how much longer policy should remain "substantially" restrictive. As inflation eases further, the Fed will need to act to prevent real interest rates from rising further and risking a recession. However, before lowering rates, the FOMC needs more assurance that inflation will "sustainably" return to the 2% target, which will likely require a couple months of subdued price readings. We expect the Fed to lower rates three times this year, starting in July. QT tapering, or slowing the runoff of its bond portfolio, should also begin this summer.

Canada

Canada's economy met expectations of a sharp deceleration last year, but has recently surprised to the upside. Real GDP growth slowed to 1.1% in 2023 from 3.8% in 2022 amid weaker consumer spending and declining business investment. However, after contracting in the third quarter, the economy has stepped back from the recession edge, with real GDP rising 1.0% annualized in Q4 and expanding further in the first two months of 2024. Motor vehicle sales have accelerated to the highest level in the post-pandemic period. The downturn in the housing market has bottomed due to a pullback in mortgage rates and the prospect of more rate relief to come. Accordingly, we lifted our GDP call for the first half of the year and now expect growth to improve slightly to 1.2% for all of 2024. Unfortunately, that's still below potential, implying upward pressure on the unemployment rate. Renewed mortgage contracts should continue to hinder spending, while a sharp rise in business bankruptcies could tap the brakes on hiring. However, the economy is expected to see decent 2.0% growth in 2025 as a result of easier monetary policy starting this summer.

The gravitational pull of a weak economy has caused the inflation tide to retreat. Since peaking in mid-2022, the annual CPI rate has fallen more than five percentage points to 2.8% y/y in February, though most core metrics are running slightly faster due to heated shelter costs. Wages are also running above 4%, conspiring with weak productivity to boost unit labour costs 4.6% y/y in Q4, and adding stickiness to inflation. Still, with the current 5.8% jobless rate a full percentage point above its cycle low and expected to reach 6.5% later this year, wage growth should moderate, allowing inflation to return to the 2% target by late 2025.

Given calmer prices and a sluggish economy, the Bank of Canada no longer believes rates need to rise further to achieve the inflation target. Still, it's in little hurry to reverse gears, patiently waiting for "further and sustained easing in core inflation" before making a move. We expect the Bank to reduce policy rates from 5.0% starting in June to 4.0% at year-end and eventually to below 3.0% in early 2026.

The Canadian dollar remains locked in a narrow, low range centered around $1.35. Given the country's poor economic and productivity performance, it is unlikely to take flight. However, assuming the trade-weighted greenback continues to retreat from earlier record highs, the loonie could strengthen modestly toward C$1.32 by year-end.