North American Outlook

August 06, 2024 | 16:42

Let the (Easing) Games Begin

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 Fed will soon join the Bank of Canada in easing policy and both will likely move more forcefully than previously expected as rising joblessness supplants high inflation as the bête noire
Lower interest rates should revive economic growth moderately next year

United States

The Fed is going for gold. A rare soft landing for the economy is still within reach despite a soft patch of data and the early-August financial market flare-up on fears of a recession. Growth has moderated enough to relieve inflation pressures, yet without causing widespread layoffs. We still expect the Fed to stick the landing, though a rising jobless rate and geopolitical tensions risk a misstep.

Real GDP growth doubled in the second quarter to 2.8% annualized, offsetting the slow start to the year. Spending by the big three engines—consumers, businesses, governments—picked up steam. Household spending was supported by rising equity and home prices, and, until recently, solid job gains. The sole weak spot last quarter was construction, both residential and commercial, with the former groaning under the weight of a generational slide in housing affordability and the latter held back by a struggling office market. However, with interest rates still elevated and excess savings mostly depleted, growth looks to downshift to 1.3% in the third quarter. Slowing employment, declining manufacturing activity, and tepid services sector growth in July support this call. Still, with interest rates heading lower, continued positive growth of 1.7% is expected in 2025.

The labour market, long a pillar of support for consumers, has weakened. Nonfarm payroll gains slowed to an average of 170,000 in the three months to July from 218,000 in the previous three months. Though still reasonably healthy, job creation hasn't kept pace with an expanding labour force. The unemployment rate has risen 0.9 ppts from its half-century low, an increase normally seen in recessions. The current level of 4.3% is likely above the 'natural rate' consistent with stable inflation. Fewer job openings also suggest that labour market conditions have loosened after a period of extreme worker shortages, resulting in some moderation in wage growth. Simply put, the job market is likely no longer a source of inflation pressure, and will weaken a little further before growth improves next year.

A looser labour market was needed to break the back of stubborn services inflation. Lending a hand is sturdy productivity growth, up 2.7% in the year to Q2, a full percentage point faster than the half-century norm. As a result,unit labour costs are up just 0.5% y/y, the slowest rise in nearly five years which, if sustained, could lead to inflation undershooting the target (and/or businesses expanding profit margins). After a surprising upturn in the first quarter,inflation has reversed course. The Fed's preferred measure, the deflator for personal expenditures, is running just 2.5% in the past year to June, with the core rate a tick higher. Both are within easy reach of the target, though more challenging base effects could limit their decline this year.

Few pundits expected the Fed to lower policy rates on July 31, and it didn't. But most thought it would signal plans to move on September 18, and it did. With the FOMC "attentive to the risks to both sides of its dual mandate", lowering inflation is no longer the sole focus of policy. In fact, the recent spike in the jobless rate virtually cements a rate cut at the next meeting. The only question is: by how much? The current policy stance is clearly restrictive and will become even more so if inflation continues to fall. Financial markets are now pricing in a high chance of a 50-bp cut in September. In our view, that's possible if the August jobs report shows further weakness or financial markets remain unsettled. For now, we expect 25-bp moves at each of the next five policy meetings through March, with the easing cycle wrapping up in early 2026, or a year sooner than previously thought. We still look for a cumulative 225 bps of rate reductions.

With the policy debate shifting from timing to pace, Treasury markets have rallied hard, driving the 10-year yield below 4% for the first time in six months. We expect it to trough at 3.5% in 2025, a half percentage point lower than previously thought. Thirty-year mortgage rates have fallen one percentage point since October 2023, but remain elevated at 6.7%, about two percentage points above the two-decade norm. As borrowing costs decline further, economic green shoots should show up first in the beaten-down housing market.

Canada

While the Fed slowly built its case for easier policy, the Bank of Canada had little trouble recognizing the need for interest-rate relief. Canada's economy has underperformed the U.S. for more than a year, despite the benefit of torrid population growth. That underperformance likely continued in the second quarter, even if growth looks to improve to around 2% annualized amid decent gains in May and June (flash) GDP. The opening of the expanded Trans Mountain pipeline has juiced energy exports, supporting the trade balance. Still, Canada's economy likely grew less than 1% in the past year, despite its major trading partner expanding a solid 3.1%. This speaks to the underlying weakness in both demand and productivity. Retail sales have been particularly soft, with volumes up just 0.7% in the past year to May, as households have cut back amid resetting mortgage payments. Housing market activity in Ontario and B.C., the two most expensive provinces, remains depressed due to poor affordability, though other regions are benefiting from migrants searching for less expensive properties. In Toronto, existing home sales have fallen in five of the past six months to July, while a glut of investor-owned condos has led to the most active listings since the financial crisis. Benchmark prices are 5% below year-ago levels, largely due the weak condo market. For all of 2024, Canada's economy looks to grow 1.1%, about in line with last year's tepid performance, before rate relief kicks in and spurs a moderate pickup to 1.8% in 2025.

With job growth slowing and the labour force surging, the unemployment rate has spiked 1.6 ppts in the past two years to 6.4% in June. A further increase is expected before a firmer economy and slower population growth come to the rescue. The latter, however, will require the federal government to move on a pledge to slash temporary immigration. Increased slack in the labour market has helped grease a slide in CPI inflation to 2.7% in June with the key core metrics now tucked below 3%.

Falling inflation and rising joblessness suggest the Bank of Canada will continue to ease policy. The Bank lowered rates another 25 bps in July and signaled more to come, with Governor Macklem noting "the downside risks are taking on increased weight" in policy decisions and "we need growth to pick up so inflation does not fall too much". We now look for a further 75 bps of rate reductions this year and a similar amount next year, taking the policy rate to 3.0% by mid-2025, reaching neutral nearly a year sooner than previously thought.

The Bank's head start on the Fed in the rate-cutting race hasn't been kind to the Canadian dollar. Even against a softening greenback, the currency is languishing at the lowest levels since the 2020 shutdowns. Given negative Canada-U.S. rate spreads, a chronic current account deficit, and the nation's slide down the global competitiveness scale, the loonie could weaken modestly further to C$1.40 (US$0.714) by year-end.