North American Outlook
February 15, 2023 | 13:16
The U.S. economy has shown surprising resilience in weathering a blizzard of Fed rate hikes. Real GDP grew 2.9% annualized in Q4, hardly slowing from the prior quarter's pace, though half of the increase stemmed from a large inventory build that will weigh on future quarters. Nonfarm payrolls soared over half a million in January, even topping the strong average pace of last year, while retail sales shot up by 3%. The resilience largely reflects three factors. First, the lagged effect of policy changes suggests the full force of earlier rate increases won’t be felt until later this year. Second, consumers still have some pent-up demand for travel, in-person events and motor vehicles. Third, households are tapping a reservoir of savings to mask the sting of high inflation. An estimated draw down of around $800 billion in the past year is equivalent to 4% of after-tax income. The remaining firepower could last a year and will go a long way to allaying headwinds. Companies also built up large cash buffers that they are using to buy machinery and automation as a substitute for scarce workers.
Still, the economy has lost some stamina and will likely face a mild slump this year due to tighter financial conditions. A downturn would validate the often reliable signal from a sharply inverted yield curve and a lengthy decline in the leading indicators index. Revenge spending will fade over time, causing hiring to slow and layoffs to mount. The correction in house prices will continue, with a 15% decline likely required to restore affordability from the worst levels in a generation. However, the recent sharp drop in mortgage rates should put a floor under home sales soon. A divided Congress limits the prospect of expansionary fiscal policy, notwithstanding some bipartisan support for modest spending measures. We expect real GDP to contract modestly in the spring and summer, while registering 0.7% growth for the full year. The downturn should lift the jobless rate to 4.8% by year-end from the current 54-year low of 3.4%.
Barring a resurgence in resource prices (and oil in particular), inflation has peaked. Goods prices are trending lower as retailers discount items to clear excess stock and cost-conscious consumers push back against price hikes. Supply chain pressures have eased amid lower shipping rates, less congested ports, and improved delivery times. Increased automation has lessened the strain of worker shortages. However, steady (albeit easing) wage pressure is keeping services inflation elevated. For this reason, we see the CPI rate hovering around 3% y/y at year-end. This would mark a big step back from last June's four-decade high of 9.1% and the latest 6.4% rate, but would still be uncomfortably above the 2% target.
The Fed continues to signal a need for further rate increases. The median forecast (as of December) of the FOMC members called for policy rates to rise 75 bps this year to just above 5%, the highest since 2007. After raising rates 25 bps on February 1, the committee appears to be sticking with this earlier call, with the press statement claiming that "ongoing increases" are still appropriate and Chair Powell saying that we are "not yet at a sufficiently restrictive level on rates". Following the strong jobs report, we now concur with the FOMC's view of two more rate hikes, likely in March and May. Long-term rates have fallen this year in anticipation of an eventual policy reversal, but we judge the Fed will hold tight until early next year to limit the risk of overshooting its inflation goal. We expect a modest, temporary backup in long-term rates in the months ahead.
The risks to our outlook are two-sided. Stubborn inflation could require even more restrictive policy, leading to a much harder landing. We attach roughly 15% odds on this scenario. However, there's likely a greater chance (35% odds) of avoiding a downturn all together if inflation falls more rapidly, paving the way for an earlier policy reversal and easier financial conditions. A possible escalation of the Russia-Ukraine war poses an ongoing threat to the global economy. Another potential landmine is if Congress fails to address the debt ceiling before the Treasury Department exhausts so-called extraordinary measures, at which time—early June according to Treasury Secretary Yellen—the government will risk default. While Congress will probably act at the last minute to prevent such an unprecedented event, credit-rating agencies could still move to reduce the nation's credit rating, as per S&P in 2011. Its downgrade sent equity markets tumbling at a time when the economy was on an upswing from the Great Recession; a setback this time could strike when the economy is on its back heels.
Canada's economy also put up a good fight in 2022, growing at a steady rate of around 3% in the first three quarters. But, outside of labour markets, momentum has faded with real GDP rising only slightly in October and November before stalling in December according to StatCan's initial estimate. The goods-producing side of the economy (manufacturing and construction, notably) is now contracting, offset by continued growth in services. But discretionary spending on travel and in-person services is about to fade due to high inflation and rising credit costs. With mortgage payments resetting at rates some 3-to-4 percentage points higher than at origination, indebted households will need to cut spending by many thousands of dollars each year. That expectation is likely propping up the personal savings rate. While existing home sales (down 37% y/y in January) could bottom soon given some recent easing in fixed mortgage rates and a likely pause on policy rates, a hearty recovery is unlikely given still-poor affordability. Despite a 15% decline in benchmark prices from early last year, affordability remains near generational lows. A further correction is needed to bring buyers fully back to the game. Meantime, exporters face sagging global demand, with limited relief from a competitive currency.
Canada's economy looks to contract modestly for a couple of quarters while registering 0.7% growth for all of 2023. The downturn will be tempered by high household savings, a modest expansion in fiscal policy (nearly every province is providing some type of inflation aid to households), and rapid population growth (2.3% y/y in Q3, tops among G7 nations). After a record job gain in January (outside the pandemic period), the unemployment rate is expected to rise to 5.9% at year-end from the current rate of 5.0%, while remaining below long-run norms.
Inflation has retreated from four-decade peaks on cheaper fuel and weaker goods demand, but it remains high at 6.3% y/y in December. Shorter-term trends in the core measures are running in the 3%-to-4% range, well above the 2% target. With the CPI rate expected to hover near 3% at year-end, the Bank of Canada is unlikely to reverse policy gears until early next year. However, after raising rates by 25 bps on January 25 to the highest level (4.5%) since 2007, the Bank signaled a pause in the tightening cycle, conditional on inflation tracking back to the 2% target in 2024.
Although interest rates won't rise as much as in the U.S., Canada's economy probably won't fare much better this year. Canadian households are more indebted and, thus, sensitive to higher loan costs, and do not benefit from 30-year fixed-rate mortgage terms. Moreover, when the U.S. economy spins in reverse, Canada usually gets vertigo, meaning it won't be immune from the U.S. debt ceiling drama.