Can the Fed Cut Rates in September?

Major central bank rate cuts have begun. Quarter point rate cuts from the Bank of Canada and the ECB this week with pledges to follow with more, herald a major shift in the global monetary policy wind for the first time in more than two years of inflation fighting. It also has investors on high alert for any new signs from the labor market and inflationary environment that could be justified by a “data dependent” Fed to allow them to follow with a rate cut of their own as soon as September.

Unfortunately, this week brought more ambiguity on the labor market front that will do little to settle the rate cut debate. Some less scrutinized reports offered tantalizing evidence of a gradually cooling, but not yet ice-cold, job market. Others, like the May Establishment Survey, showed remarkable resilience with better-than-expected nonfarm payroll growth at 272k and average hourly earnings growth up to a hot 4.1%, hardly a signal of moderating demand. So which view of the labor market is closer to reality? We think the totality of the evidence supports the thesis that at least a modest labor market slowdown is underway in the second quarter that should continue to work toward the Fed’s goal of labor market rebalancing.

The Household Survey provides the best evidence of a cooling labor market (Chart 1). Household employment plunged by 408k in May, pushing the unemployment rate up to a new tightening cycle high of 4.0%. The unemployment rate has risen by sixth tenths of a percentage point since April 2023, a clear sign job growth might not be as strong as the Establishment Survey indicates. In contrast, the Household Survey has shown outright net job losses now in four of the last six months. Moreover, the BLS recently released the 2023Q4 county level employment and wage (QCEW) data that points to a sizable over-count of around 730k jobs in the Establishment Survey from last year. If the Establishment Survey overcounted job growth last year, it probably is overcounting job growth this year too.

The April JOLTs data this week also revealed another drop of nearly 300k open positions to just over 8 million. From a year ago, job openings have fallen by 1.85 million positions as employers’ labor demand growth slows. Job openings are now less than a million above pre-pandemic levels and have dropped by a third since hitting a peak of 12.182 million in March 2022 when the Fed began its historically aggressive monetary tightening. Excess job openings, defined as job openings minus the number of unemployed people, are just 467k above pre-pandemic levels, with the labor market now looking nearly fully re-balanced by this measure (Chart 2).

The cooling breeze sweeping through the labor market was also corroborated by the latest initial jobless claims data (Chart 3). They jumped to 229k in the week of June 1st, with the four-week moving average holding near its highest level of the year at 222k and reaching levels not seen since September 2023 in the aftermath of the regional banking crisis. From an overall labor market perspective, there don't appear to be any major red flags that would keep the Fed from eventually starting the rate cutting process from its current highly restrictive stance.

Up next Wednesday is the May CPI inflation report that is released on the same day as the June FOMC decision. We expect the report to show more encouraging evidence of inflation moderation, but it probably won’t be definitive enough for the Fed to green light a rate cut before September.

FOMC Preview: Staying the Course

We expect no change in Fed policy rates on June 12, marking the seventh straight meeting with the fed funds target range being held at 5.25%-to-5.50%. And among the statement, projection materials and press conference, we reckon a common message will be to expect more of the same in the months ahead.

Last confab’s policy statement introduced the phrase: “In recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective.” Indeed, monthly inflation performance deteriorated meaningfully during the January-March period. However, April’s inflation readings improved from March’s moves (and Q1’s averages). More improvement is required to confirm the recent acceleration was more anomaly than trend, and steer the three-month changes back to where they were before the pickup (which, for the underlying PCE price indices, was already the stuff of Fed rate cuts). Interestingly, the FOMC will get the May CPI report at its meeting. We’re expecting an April-matching +0.3% move in the core metric, still not enough to sufficiently erase the memory of the 0.4% trifecta that started the year. We look for the new phrase to be repeated, signaling the Fed is on hold until better inflation data arrive.

The Summary of Economic Projections (SEP) should show less appetite for rate cuts, particularly for this year, compared to the previous report. March’s SEP had 75 bps of cumulative rate cuts in each of 2024, 2025, and 2026, according to the median projection. However, even at the time, this year’s call was tenuous, with 10 participants projecting at least three quarter-point moves (9@3,1@4) and nine policymakers forecasting two or fewer actions (5@2,2@1,2@0). We look for the latter clan to now dominate, with the median projection sporting two rate cuts. To drop this down to only one move would require around one-third of participants newly adopting this view, which we reckon is a tall order. As for 2025 and 2026, March’s median calls were also tenuous, with 75 bps (or less) of cumulative rate cuts supported by 10 (of 19) participants. As such, the degrees of easing and/or ending levels will likely change, if only to account for the higher starting point. Finally, for the longer-run level, March’s median projection fell in between 2.50% and 2.625%, having been bumped up from 2.50%, and a further bump could occur.

Elsewhere in the SEP, with policy rates remaining higher (at least for this year) and given the starting points (real GDP growth 1.3% annualized in Q1, unemployment rate 4.0% in May), March’s median projections for 2024Q4 growth (2.1% y/y) and joblessness (4.0%) will likely be revised down and up, respectively. The 2024Q4 projections for total and core PCE inflation (y/y) should also be revised up from 2.4% and 2.6%, respectively (they were both 2.8% in April). The latter suggests policy rates could remain higher next year too.

In Chair Powell’s presser, we suspect he’ll emphasize that, although the labour market continues to move into better balance (despite May’s sturdy growth in payrolls and wages), inflation is still too fast for comfort. And expect Powell to re-assert that policy is still “sufficiently restrictive” to rein inflation in further, and more rate hikes are “unlikely”. Given comments by other Fed officials, we wouldn’t be surprised if Powell proffered that, while unlikely, rate hikes are not ‘off the table’. This should cast a net hawkish tone over the entire proceedings.

Housing Under Pressure… Yet Prices Keep Rising

In a typical monetary policy-driven housing market downturn, home sales fall on weaker demand causing home prices to drop as the market moves to a new equilibrium. However, this housing market downturn has been anything but typical, although home sales have stuck to the script. Existing home sales have declined y/y for an astounding 33 straight months and remain 26.5% below March 2022 (Chart 1), when the Fed’s fierce monetary tightening effort started.

Still, prices continue to march higher. The median existing home price climbed 5.7% year-on-year in April to $407,600, the fourth-highest on record and just 1.5% shy of the all-time high of $413,800 in June 2022. Over the past four years, prices are up 42.1%. By early 2023, they had looked a bit less sturdy under the strain of rising mortgage rates. Yearly growth weakened significantly in late 2022 and prices declined modestly for four months in a row from March 2023 through June. However, more recently, home price growth has mostly re-accelerated, and April’s 5.7% pace is the strongest since October 2022. Year-ago growth is varied across regions, ranging from a comparatively weak 3.7% in the South to a solid 9.3% in the West (Chart 2).

The main support to rising home prices has been too little supply, as many homeowners remain reluctant to list their home for sale amid high mortgage rates. The so-called “locked in effect” is powerful for anyone with a sub-3% mortgage who doesn’t want to trade it for one that’s at least twice as high. The months’ supply of existing homes for sale at the current sales pace was 3.5 in April 2024 (Chart 3), up from 3.2 in March and 3.0 a year ago. While inventory has improved somewhat, months’ supply is still well below the long-run average of 5.3 from 1999-2023.

There is some relief to rising home prices on the horizon, however. The number of homes under construction was 1.62 million in April and has been at or above 1.60 million since March 2022 as builders attempt to make up for the shortage of existing homes for sale. This is the highest sustained construction clip in history. Additional relief could come from lower interest rates. We expect the Fed to start easing in September, which will translate into slightly lower mortgage rates into 2025 and might prompt some homeowners who are on the fence to list their homes for sale next year. However, with more than 90% of mortgages sporting rates under 6% (according to Redfin), this might not be a huge relief factor.

Bottom line: The improving inventory situation will eventually bring the housing market into better balance and take the steam out of home price increases. Accordingly, we expect home price growth to moderate to 2.6% in 2025, about half of the 5.1% increase we are projecting for 2024. The deceleration will be warmly embraced by homebuyers who have been priced out of the market by challenging affordability.

U.S.-Canada Matters: Three Key Themes

In the lead-up to this year’s elections, there are three dominant and disparate topics in the Canada-U.S. relationship that bear watching: trade, immigration, and a growth/inflation divergence.

1) Industrial and Trade Policy: Trade in a Time of Chaos

With the U.S. election fast approaching, no area of economic policy has received more attention than trade and industrial policies. Both political parties have moved toward a more protectionist stance in the past decade, with subsidies and tax incentives seeing strong take-up. For example, the Congressional Budget Office (CBO) recently estimated the energy components of the 2022 Inflation Reduction Act could cost US$800 billion over ten years, over twice the initial estimate of $391 billion.

Both parties have also placed import tariffs on legacy industries facing competition with China. Most recently, President Biden imposed or raised tariffs on approximately $18 billion worth of annual imports from China. He also maintained President Trump’s earlier tariffs on over $300 billion worth of Chinese goods. Donald Trump has said that, if re-elected, he would add further restrictions to Chinese products and investment. And, he would subject all imports, regardless of origin, to an additional 10% tariff and impose a new tariff of 60% or more on all imports from China.

On net, higher tariffs are expected to weigh on U.S. GDP growth, as the hit to real income and spending from higher prices outweighs the improved trade deficit and tax revenue, especially if other countries retaliate. Indirect impacts could include a sharp deterioration in financial conditions and business and consumer sentiment, along with more uncertainty in trade policy. Tariffs can effectively be a regressive tax on domestic consumption, i.e., the burden is largely borne by lower-income households as a higher share of their income goes to spending. According to the Peterson Institute for International Economics, Trump’s proposed new tariffs would cost U.S. consumers at least 1.8% of GDP before accounting for retaliation and lost competitiveness—nearly five times larger than the cost of the 2018-2019 U.S.-China trade war (Table 1).

These measures could also counter the Fed by temporarily raising broader inflationary pressures. Studies from the 2018-19 episode show the impacts fell almost entirely on the U.S. consumer and provided cover for domestic producers to also raise prices. Still, the overall inflation impact should be relatively modest, with each 1 ppt increase in the effective tariff rate expected to lift U.S. core consumer prices by around 0.1 ppt. Given Canada’s reliance on U.S. trade, some of this may flow through to Canadian CPI.

As of 2023, Canada was the United States’ second-largest trading partner, moving back above China, but below Mexico (Chart 1). Canada was the top destination of U.S. exports (about 17% of the total) and third-largest source of U.S. imports, behind China and Mexico. Canada’s share of U.S. imports has trended down from around 20% in the mid-1990s to just above 13% now.

However, one potential concern is the widening U.S. bilateral trade deficits with both Canada and Mexico (Table 2). While not nearly as lopsided as U.S. trade with China, the recent imbalances with these two trading partners could become a political flashpoint for the next U.S. Administration. So far, U.S.-Canada bilateral trade has largely side-stepped the worst of this protectionist pivot, somewhat shielded by the 2020 USMCA. Even so, the Trump Administration raised tariffs on steel and aluminum from Canada, along with most countries, from mid-2018 to May 2019, when the tariffs on Canada were lifted as part of the USMCA negotiations. The USMCA is due for review in 2026, potentially pulling Canada and Mexico directly into the crossfire. For Canada, the wider trade imbalance has been driven by the back-up in energy prices and some increase in oil volumes. Still, the combined share of the U.S. trade deficit from Mexico and Canada has pushed above 20%, comparable to the EU and not far below that of China.

Moreover, we note two things: 1) Some of China’s exports to the U.S. are likely being re-routed to avoid tariffs, understating the bilateral U.S.-China imbalance, while potentially overstating Mexico’s imbalance; and 2) the ratio of U.S. exports to imports is still much healthier with Canada (85.0% in the past 12 months), and with Mexico (67.2%), than with China (34.2%). In other words, there really is no equivalent comparison between the overall imbalance in trade flows with the rest of North America and that with China.

Finally, Canada (and Mexico) could face additional challenges on trade policies aside from USMCA renewal. For instance, if Canada is compelled to move in lock-step with the U.S. on tariffs on Chinese EVs and other products, it could spark bilateral trade pressure from China. This could hit Canada harder given China’s importance as a destination for Canadian agricultural and forest products.

2) Immigration: Large Shifts

The U.S. has seen a large influx of immigrants since the pandemic reopening. The CBO estimates that 3.3 million net immigrants arrived in the U.S. in 2023 (or roughly 1% of the resident population) compared with around 1.0 million a year prior to the pandemic. The CBO estimates that strong migration will continue at least over the next two years before moderating back toward pre-pandemic levels.

At the same time, net immigration in Canada has reached record highs, with population growth at its highest pace since the late 1950s (3.2% y/y as of the start of 2024). New immigrants skew younger, bolstering the prime age working population at a time when the domestic population is aging. The Canadian government’s recently announced caps on international students and non-permanent residents (details of which will be announced later this year) are expected to bring Canada’s population growth down to a more manageable 1% y/y pace starting in 2025.

In the near term, the immigration surge has added to demand for housing, transportation, food, health care, and other services. At the margin, this likely contributed to elevated price pressures, especially when housing markets were particularly tight.

Yet, many of these new immigrants have bolstered labor supply and employment metrics over the last two years. In the U.S., the BLS estimates the labor force participation rate for immigrants in 2022 was around 50%. According to Statistics Canada, the participation rate for immigrants (landed within five years) is above 70%—that’s higher than the overall rate of just over 65%, likely reflecting the younger demographic of recent arrivals. In both countries, higher immigration means that employment growth doesn’t need to slow as sharply to bring the labor market into better balance.

For instance, the Brookings Institution estimates the U.S. labor market can now accommodate monthly employment growth of roughly 160k-to-220k without adding to wage and price inflation pressures. This was especially evident in last year’s stellar job and real GDP growth performances even as consumer inflation rates cooled. However, the upcoming U.S. election raises uncertainty over immigration policies and, thus, the estimates of potential non-inflationary job growth.

Canada’s recent population surge has been nothing short of dramatic. Even smoothed over a five-year period, population has risen at a 1.8% annualized rate, the fastest such pace in over 50 years. Temporary foreign workers are the top factor, but the surge is also driven by international students and refugees, who may not necessarily join the workforce. As well, the peak of the Baby Boom is reaching retirement age, so Canadian labor force growth is not nearly as steep as total population. Still, Canada’s labor force has grown at roughly twice the pace of the U.S. workforce over both the past 5 and 25 years (Chart 2).

Notably, the wide gulf in Canada-U.S. population and labor force growth has not translated into faster economic growth for Canada. A much weaker productivity performance has resulted in Canada lagging behind the U.S. in real GDP growth over the past five years (Chart 3). Even over the longer term, both countries have posted nearly identical GDP growth rates over the past 25 years (2.1% for Canada, 2.2% in the U.S.), even though Canada’s labor force has expanded almost twice as quickly on average over that period (1.4% versus 0.8%).

3) Growth Divergence: This, Too, Shall Pass

Canada’s growth underperformance relative to the U.S. has deepened in the past year. Looking through the quarterly wobbles, real GDP in Canada is up by less than 1% in the past four quarters (to 2024 Q1) versus nearly 3% U.S. growth over the same period.

The gap is primarily driven by the greater sensitivity of Canadian consumers to higher interest rates than their U.S. counterparts, due to a higher concentration of short-term fixed-rate mortgages and larger debt loads (Chart 4). Canada’s mortgage market is largely comprised of variable-rate and shorter-term fixed rate mortgages, typically five years or less (versus the availability of 30-year fixed-rate mortgages in the U.S.). Normally, this difference in mortgage terms doesn’t have a large bearing on growth differentials—but these are not normal times, given the extraordinary rate hikes in 2022/23. We’ll note that amid all the clamoring for the option of much longer-term mortgages in Canada, U.S. 30-year mortgage rates are now hovering around 7%, far above the five-year rates on offer in Canada of closer to 5%.

Despite the negativity swirling around Canada’s growth performance, we believe that there are grounds for optimism over the medium term. Strong population growth and earlier rate cuts drive of our forecast for a notable rebound in Canada’s real GDP growth in 2025—back to around 2%. The relatively weak growth of 2023/24 has allowed inflation to cool more rapidly, bringing it within sight of the 2% target.

Another reason for guarded optimism for Canada is the fiscal backdrop. While far from pristine, Canada’s fiscal fundamentals are less concerning than those of the U.S. and many European economies. The IMF estimates Canada’s general government budget deficit at just over 1% of GDP this year, well below that in Europe (2.9%) and the U.S. (6.5%). The IMF estimate for Canada may be too lenient, as this budget cycle points to a combined federal & provincial deficit of just over 2% of GDP, still on the low end of major economies. This acts as a non-negative for Canada, as others face serious fiscal restraint in coming years. For longer-term consideration, the IMF estimates that Canada’s general government gross debt will rise to nearly 105% of GDP in the coming year, well below the U.S. (over 120%), but in line with the U.K. and above Germany.

Altogether, the Canada-U.S. gaps in growth and inflation will lead to short-term divergence in monetary policy and additional softness in the Canadian dollar. This could aggravate the U.S.-Canada trade imbalance—amid sluggish Canadian spending (and imports) and an even more competitive exchange rate. However, we suspect that the U.S.-Canada growth gap will soon narrow; the sensitivity of Canadian consumers to interest rates will turn from a drag to a lift as borrowing costs recede.

With thanks for the assistance of Shelly Kaushik. [A more detailed special report is also available here.]