North American Outlook

May 16, 2023 | 10:08

Banking Strains Will Stress Economy

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

Tighter lending conditions raise the chance of a recession, but should also dampen inflation and could limit the need for further policy tightening.
We still expect a shallow downturn for the U.S. and Canadian economies, with very modest growth in the year as a whole. This assumes current stability in the banking system holds.
The Fed and the Bank of Canada should stand on the sidelines for the rest of the year, before easing policy starting in early 2024.

United States

With the risks of additional bank failures fading, a sense of calm has returned to financial markets. This follows the failure of three sizable U.S. banks, the latest being First Republic. The banking stress has eased with the initial sharp drop in deposits and lending now stabilizing, leaving the financial system still flush with liquidity. The Fed's emergency support to banks has also ebbed. However, higher deposit rates have increased bank funding costs and pressured loan margins, reducing the incentive to lend. Consequently, lending standards, which were tightening before this year, have become more restrictive, according to the Fed’s latest survey of bank loan officers. Small businesses are feeling the pinch, as loan availability fell to the lowest level in at least five years, finds the NFIB. Tougher lending conditions will only compound the lagged effect of the most aggressive rate increases in four decades, testing the economy's resilience. We still look for a mild, two-quarter recession that lifts the unemployment rate by more than one percentage point to 4.8% at year-end.

The U.S. economy slowed to an annual rate of 1.1% in Q1 from 2.6% in Q4, as weakness in business spending, inventory investment and residential construction largely offset robust gains in household and government spending. While consumer spending accelerated 3.7%, much of the gain stemmed from warmer weather and higher Social Security payouts in January. Consumers have downshifted more recently, and the economy itself has lost steam and looks poised to contract slightly in Q2. The weight of higher borrowing costs and tighter lending conditions should counter the lift from excess savings and pent-up demand for services and autos. For besieged office properties already facing rapidly rising vacancy rates, the mild recession will compel companies to reduce headcounts and space, aggravating the secular challenge arising from the adoption of hybrid work.

A recession is the timeworn cure for high inflation. While the annual CPI rate has fallen from four-decade highs of 9.1% last summer to 4.9% in April, the core rate is proving much stickier, down just over one percentage point to 5.5% and still running at 5.1% annualized in the past three months. Cheaper gasoline and some recent moderation in food inflation explain the faster decline in the headline rate. Helping the cause, global supply chain pressures have normalized after three years of disruptions and delays, according to the New York Fed. Still, minimal slowing in wage growth suggests prices in the labour-heavy service sector will continue to run hot. We still see a 3-handle on inflation at year-end.

With banking stress calming and core inflation stubbornly high, the Fed raised rates by 25 bps on May 3. However, it signalled a potential pause in the rate cycle to assess the impact of 500 bps of cumulative increases on the economy and inflation. The shift reflects concern that further tightening could lead to a harder landing for the economy and the financial system. While investors expect policymakers to reverse gears later this year, we suspect that worries about reigniting inflation will delay rate cuts until early next year. The Fed should then slowly guide rates back to more neutral levels of around 2.6% in 2025. The current 10-year Treasury rate of 3.5% should then drift down to around 3.0% in that year.

Canada

Canada's economy also bolted out of the gate this year, but has since shifted to a slower gait. Juiced by unusually mild weather in January, real GDP rose the most in ten months (0.6%), before slowing sharply in February and contracting slightly in March according to Statistics Canada's initial read. While growth likely rebounded to 2.5% annualized in Q1, the weak handoff, together with some hit from the federal public sector workers' strike (now settled), points to a modest contraction in Q2. The slump should take some steam out of the labour market after employment rose the most on record (outside the pandemic) in January, before moderating to a still-solid pace in the following three months. Meantime, the year-long correction in the housing market appears to have ended. Existing home sales rose in the past three months to April, as lower prices and the central bank's rate 'pause' pulled prospective buyers off the fence. After sliding 16% since early 2022, benchmark prices have risen the past two months.

Even if credit conditions in Canada tighten less than stateside, the economy is unlikely to avoid a mild, two-quarter recession. The global financial stress will have knock-on effects for domestic businesses. While interest rates haven't risen as much as in the U.S., households are more sensitive due to larger debts and shorter mortgage terms. With policy rates now the highest since 2007, many younger mortgage holders have never faced high borrowing costs and will be compelled to cut back on discretionary spending. Consequently, real GDP growth is expected to decelerate to 1.0% in 2023 from 3.4% last year, before expanding 1.3% in 2024. Some modest net fiscal stimulus announced in the federal budget will provide support. The unemployment rate could rise from 5.0% in April to 5.8% by year-end, a modest increase compared with past recessions.

Inflation continues to fall. After poking its head above 8% last summer, the annual CPI rate is down to 4.4% in April. However, the core measures indicate stickiness, suggesting further progress in reducing inflation could be more challenging in the face of tight labour markets. Assuming the economy weakens further, we expect inflation to ease to around 3% at year-end, before making a more concerted move toward the 2% target next year.

The Bank of Canada held policy rates steady at 4.5% in April, sticking with its earlier guidance to pause and assess the impact of past actions on the economy and inflation. However, the Bank underscored the conditional nature of its decision, warning that either stronger growth or stickier inflation could pull it off the sidelines. We still see no further policy changes this year, with rate cuts likely to begin by early 2024. Ultimately, policy rates are expected to gravitate toward less restrictive levels of around 2.5% in 2025.