North American Outlook

May 12, 2022 | 10:57

Hawk Talk

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 banks may need to jam on the brakes to rein in inflation, risking sending the economy into a skid

With some luck on the inflation and Ukraine fronts, however, the economy should steer clear of a downturn though not a downshift, with support from high household savings

To Neutral—and Beyond?

Central banks no longer believe inflation will return to target without forceful policy action. The Fed and Bank of Canada have now taken off the gloves in the inflation fight and are prepared to do whatever it takes, even at the cost of a downturn. Small jabs are no longer an option; a knockout blow is needed this late in the round. Bank Governor Macklem didn't mince words, saying "the economy is overheating, that’s creating domestic inflationary pressure”. The pressing goal is to bring policy rates to neutral (between 2% and 3%), before stepping back to judge the impact. If inflation is still standing, then further action will be required. The problem is that both central banks, and especially the Fed, have much catching up to do. We see the Bank raising its policy rate by another 50 bp at each of the next two meetings and ultimately take it to 2.75% next April. The federal funds rate will likely rise 50 bp at each of the next three meetings and reach 2.9% next March. Both rates are above the peak reached in the last tightening cycle, and could go even higher if inflation puts up a fight.
Going back six decades, the Fed has never pulled off a soft landing (defined as getting to price stability without a material rise in unemployment) with inflation this high and unemployment and policy rates this low. The Fed can only hope that inflation pressure stemming from high commodity prices and the pandemic's impact on labour and material supplies will reverse soon. But Chair Powell also admits that, in hindsight, he should have been tapping the brakes earlier to curb excess demand.
Before settling back on concerns about China’s COVID lockdowns, the war in Ukraine, and a steep correction in equities, long bond yields were on a one-way trip north. Ten-year government bond yields recently pierced 3% in the U.S. and Canada, doubling since the start of the year. The five-year Canada rate reached its highest level (2.9%) in more than a decade, and the near 2-pts jump in the past year was the fastest since 1995. The good news is that future monetary tightening is largely priced into the long end, limiting the prospect of further increases if policy rates rise as expected. The bad news, of course, is that central banks may need a bigger fire hose to douse the inflation flames.

Inflation is All the Rage

Recession risks are tied to the inflation outlook. CPI rates have likely peaked near current levels of 8.3% y/y in the U.S. and 6.7% in Canada, as base-year effects fade and oil prices stabilize (we see WTI prices averaging $100 a barrel this year and $85 next year). The U.S. rate is expected to fall to 7% at year-end (still very high) and to 3% in late 2023 (still above target), while Canadian rates will hover a little lower. Central bankers will need to tolerate a slow ride back to target to reduce the risk of tipping the economy into a recession. Flexible inflation targeting might allow for just such an approach, but don't expect the Fed to tout its average-inflation targeting scheme (announced in the summer of 2020), given how well it's fared so far.

Inflation risks lean to the high side. While wage growth remains calm in Canada at just over 3% y/y, the Atlanta Fed's wage tracker is running at 6% in the U.S., the fastest since 1990. Rents will also likely chug higher for some time even as house prices moderate. Input costs continue to surge, with Canada's industrial product price index up 18.5% y/y in March, the most since 1974. One glimmer of hope is that supply chain pressures might be easing. Global freight costs have fallen sharply and microchip supply is picking up, helping to recharge auto production. Still, the New York Fed's measure of global supply chain pressures is only a little below prior record highs.

Economy's Resilience Tested By Rising Rates

The North American economy retains some resilience as a result of high household savings and inventory rebuilding. In fact, Canada weathered the latest round of restrictions remarkably well, with real GDP growing 6.7% annualized in Q4 and likely 5.5% in Q1. We revised up our call on the latter following recent strong monthly GDP estimates from StatCan. Relative to the U.S., Canada has two things going for it: more pent-up demand for services given its later easing of COVID restrictions; and high commodity prices leading to the strongest merchandise trade surplus in 14 years. Growth will also get a modest bump from new spending announced in the federal budget. We look for Canada’s economy to expand 4.1% this year, marked up from 3.5% previously and tops in the G7, before slowing to 3.0% next year as interest rates rise. Oil-rich Alberta should lead the country with 5.6% growth in 2022, as gushing fiscal revenues open the door for tax cuts to help blunt the inflation pain.
After surging 6.9% annualized in Q4, U.S. real GDP shrank 1.4% in Q1. A surging trade deficit and cuts in government spending (even defense) did most of the damage. However, accelerating business investment and sturdy consumer spending indicated underlying strength in private domestic demand, which grew 3.7%. The economy may be downshifting, but it's not in recession. Growth will slow though remain positive at 2.5% this year and 1.7% in 2023, the latter slightly below potential. This is marked down by half a percentage point from earlier estimates due to more aggressive monetary action. Fiscal policy will also turn restrictive this year with the end of the supplementary child tax credit and the stalled Build Back Better plan (my, how quickly stimulus can become a dirty word when inflation hits a two-generation high).
Heading into the economic slowdown, at least employment has rarely been so good. Canada now has 457,000 more jobs than at the start of the pandemic and the jobless rate is the lowest (5.2%) in at least 45 years. Monthly U.S. payroll gains are holding above 400,000, more than double the long-run norm, with a record 11.5 million job vacancies still to fill. The unemployment rate (3.6%) should soon be the lowest since 1969. A rising participation rate (stoked by easy job pickings, higher wages, and perhaps the rapidly rising cost of living) will help the economy recover the remaining 1.6 million jobs lost in the pandemic, mostly at restaurants and hotels.
Fast-rising mortgage rates have dialed down the heat in housing markets. Earlier this year, house prices in Canada and the U.S. rose at record rates of 29% y/y and 20%, respectively, mostly in response to above-normal demand juiced by too-low interest rates. However, more recent data show sales are declining due to ebbing affordability. Housing costs are approaching 1989 levels in Canada and 2006 levels in the U.S., with neither episode ending well. We expect sales to fall below pre-pandemic levels, shifting market power away from sellers. Prices in Canada are likely to retrace part of their past year gain, while those in the somewhat less-frothy U.S. market should level out later this year. The more that central banks need to do to corral inflation, however, the greater the risk of a deep correction.
Tighter monetary policy poses the single biggest threat to the expansion. The risk of a downturn will rise sharply next year depending on how far above neutral central banks need to go to restore price stability. A recession is not our base-case view, but given the large number of things that could go wrong—persistent high inflation and sharply higher interest rates, the war spreading beyond Ukraine's borders, an extended lockdown in China, and more severe strains of the virus—the economy's resilience could be tested.