North American Outlook

November 07, 2022 | 12:51

Here Comes the Pain Again

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

Policymakers warn more rate hikes are needed to control inflation even as they are likely to slow the pace. Consequently, we expect the Canadian and U.S. economies to contract moderately in the first half of next year and unemployment rates to rise by more than a percentage point.
The Fed and Bank of Canada have raised policy rates by 375/350 basis points this year, and we anticipate an additional 100/75 bps in the months ahead.
Lower oil and resource prices have allowed inflation to ebb from four-decade highs, but restoring price stability will take time given tight labour markets.

The North American economy's rapid recovery from the coronavirus surprised most analysts. Riding an unprecedented wave of fiscal and monetary support, the resulting surge in demand was more than factories and businesses could handle in the face of persistent supply glitches. The end result was a new pandemic, one not seen in four decades: soaring inflation. Curing this illness could take even longer than curbing COVID. There is no vaccine for inflation, just the bitter medicine of high interest rates that always harms the patient—the economy. Given central bankers' unwavering resolve to tackle inflation and a resulting plunge in financial conditions, we believe the odds of a North American recession are greater than even. The downturn is likely to be moderate and short-lived, albeit with both upside and downside risks.

By our estimate, financial conditions are set to carve roughly two percentage points from U.S. growth next year and even more from Canadian GDP. This reflects expected further monetary tightening, the bear market in equities, and a further correction in house prices. The recent pullback in commodity prices, while good for inflation, will also weigh on Canada's economy.

Canadian benchmark home prices have already fallen 9%, while U.S. median prices are down 7%. We expect cumulative declines of 20% and 15%, respectively; a partial payback from record increases of over 50% in both countries from the start of the pandemic to earlier this year. Only through lower prices can affordability (as measured by the amount of income required to carry a mortgage) begin to normalize from the worst levels in a generation.

We don't see borrowing costs falling anytime soon. No cavalry is around the corner to rescue the economy or markets. Chair Powell has been especially vocal that a premature retreat on the inflation battlefield would risk repeating the policy mistakes of the 1970s. Following a fourth straight 75 bp rate hike on November 2, and cumulative 375 bps since March, he warned that policy rates are likely to peak at a higher level than previously thought, even if the pace of increases is likely to slow. He also said that rates could remain high for some time, supporting our view that reductions are off the table next year. We expect the federal funds target rate to rise a cumulative 100 bps and peak in a range of 4.75%-to-5.0% in March 2023, which is 25 bps higher than previously expected.

The Bank of Canada appears somewhat more confident than the Fed that the end of the tightening cycle is drawing near. However, it is also planning further rate increases even after lifting rates by 350 bps this year. We expect a cumulative 75 bps of increases by early next year, taking the policy rate to 4.5%, which is 50 bps higher than we previously thought due to stubborn high inflation. Policy rates are moving deeper into restrictive territory, putting the economy on course for at least a moderate downturn.

Excess household savings will only partly cushion the impact of tighter financial conditions. U.S. households are estimated to have used about a fifth of their stockpile, which peaked at $2.4 trillion in September 2021 and is now down to $1.9 trillion. This drawdown equals 2.7% of nominal personal outlays, a substantial source of spending support. However, more savings are getting gobbled up by rising prices, and high inflation will exhaust the remaining stockpile much faster than otherwise. Canadians have also racked up substantial savings, though some will no doubt be used to lighten their heavier debt burden and to counter the ravages of inflation.

Facing numerous headwinds, both economies are losing steam. Consumers are taking their lumps, with Canadian retail volumes flat-lining this summer and U.S. real spending slowing to a modest pace in Q3. We expect real GDP in both countries to expand modestly in the second half of 2022 before contracting somewhat in the first two quarters of next year, i.e., a shallow recession. With 2023 likely to mark a lost year for growth, the unemployment rate could rise by more than one percentage point, taking the U.S. rate from 3.7% in October to 5.0% in the second half of 2023, and Canada's rate from 5.2% to 6.5%. A looser labour market will take the pressure off wages and help restore price stability. It's no coincidence that, in both countries, wages and core inflation are running in the 5%-to-6% y/y range as the former is the largest driver of business costs.

Interest rates will likely rise less in Canada, where inflation is lower and wage pressures are somewhat less intense than stateside. In addition, more indebted Canadian households are particularly sensitive to rising credit costs, while most U.S. homeowners have 30-year fixed-rate mortgages that shield them from tighter monetary policy. A sliding loonie, however, could be troublesome. It recently pierced a two-year low against a surging greenback, fanning grocery bills (11% y/y to September) and overall inflation. With interest rate spreads against the U.S. moving against the loonie, the currency looks to weaken a little further to C$1.38 (72.5 cents US) by year-end.

The scope and depth of the economic downturn will largely depend on the path for inflation. Despite chopping our growth outlook in recent months, we were reluctant to lower our above-consensus call on inflation. Core measures remain elevated in both countries and prospective large wage settlements could sustain price pressure. We expect CPI rates in both countries to hover above 3% y/y even in late 2023.

Apart from stubborn inflation, the economic outlook faces other risks. High on the list is the escalating conflict in Ukraine as President Putin has warned of a nuclear response if recently annexed territory comes under attack. Tensions between the U.S. and China also continue to simmer. Several emerging market economies could face a period of instability if borrowing costs, risk aversion, and the U.S. dollar all continue to rise. However, we judge that the prospect of a widespread financial crisis in emerging nations is still low given that many countries have built up foreign exchange reserves and strengthened their banking systems, while adopting more orthodox policies in recent years, such as inflation targets and flexible exchange rate systems. That said, a further sharp drop in commodity prices could be troublesome for some large resource producers, such as Brazil, Chile and Indonesia.