- 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.