Focus
June 09, 2023 | 12:30
Where’s the Recession?
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Where’s the Recession? |
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The conventional wisdom for much of the past year has been that the North American economy has punched a one-way ticket to recession. But heading into the summer, growth on both sides of the border is holding up well, and expectations for a downturn continue to get pushed out. This is impressive resilience for two economies that have been subject to the most aggressive and abrupt tightening cycle since the 1980s. Let’s look at some of the reasons why, and where we might go from here. It’s Just Too Soon |
Yield curve predictions take time: Financial markets have been signalling the risk of a downturn, most vividly through an inverted yield curve which has a long and respected history of accurately foreshadowing downturns. Looking at the 10-year minus fed funds curve, inversion first occurs, on average, just over 14 months before the start of recession (with a range of 8-to-20 months) dating back to the late 1960s. Peak inversion occurs roughly six months before the onset of recession (Table 1). Given that the curve first inverted in November 2022, and if the May depths hold, that would place the crosshairs of recession somewhere around the end of the year—later than many initially expected, but not out of line with historical norms. Monetary policy lags: It’s well known that monetary policy acts with ‘long and variable lags’, and it’s possible that rate hikes—which were at their most aggressive last summer—haven’t worked fully through the system yet. Recent commentary from Federal Reserve officials reiterates that it has historically taken about 18 months for the full effect of rate hikes to be felt; but there is also some evidence that the lag is shortening to somewhere closer to 12 months. Our own modelling of the Canadian economy largely agrees with that broad view. That is, the incremental impact of higher short-term interest rates is largest in the subsequent few quarters, but the cumulative impact doesn’t max out until about 18 months down the road (Chart 1). That’s consistent with some sectors (i.e., housing) cracking early, but the full impact on the economy not being felt until late this year. |
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There Are Big Buffers in Place |
Excess demand for workers: Policymakers have a lot of excess demand to cut through before getting to the economy’s bone, and the labour market is a good example. Job vacancy rates in both Canada and the U.S. surged to unprecedented highs last year (Chart 2). After some pullback recently, vacancy rates today remain well above pre-COVID norms, or even past late-cycle norms. In Canada, there was roughly one vacant job available for every unemployed person before rate hikes began, an unprecedented level of tightness. That said, there are signs that momentum on this front is ebbing, perhaps reflecting early impacts of monetary tightening. But, there is still a long way to go before the Fed and BoC start creating slack in the labour market. Household savings cache: Households also accumulated significant savings through the pandemic, the result of steady job markets across most sectors, limited spending on travel and services, and fiscal transfers that ran well in excess of lost disposable income. The result is that household savings in excess of the pre-COVID baseline topped 10% of GDP, with much of that finding its way into a cache of deposits (Chart 3). Those deposits have more recently been drawn down (likely in part reflecting a shift to higher-yielding GICs and money market funds), but they highlight the economic buffer in place. Mortgage market mechanics: Higher interest rates have already triggered home price corrections, but there hasn’t been a major economic spillover yet. In the U.S., it’s relatively straightforward—most pandemic boom-era buyers locked into long-term ultra-low fixed mortgage rates. In Canada, rather than seeing payments on variable-rate mortgages rise in real time, the majority are instead seeing amortizations stretch out. This is a subtle but very important feature that has taken what would otherwise be a significant and immediate shock, and spread it out over a number of years as these mortgages trickle into renewals. Indeed, the Bank of Canada estimates a steady climb in the share of mortgages subject to higher payments through the end of 2026 (Chart 4). There’s no doubt that this will pose a stiff headwind, but it’s far less acute than if a large swath or mortgages were seeing payments jump in real time with rate hikes. And let’s not forget that most have been stress tested to handle these rates. |
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Policy Might Not Be Tight Enough |
Inflation is proving to be sticky: Central banks are finding that returning inflation to target is proving to be a challenge after some quick early gains. Core inflation trends in North America have certainly cooled, from 3-month annualized run rates in the 6%-to-8% range this time a year ago, but they are now collectively settling around 4% (Chart 5). And, it hardly matters what measure of core one looks at—ex-food & energy, trim or even the stripped down Fed-favourite ‘supercore’. At the same time, housing markets caught a bid in the spring, and if the most rate-sensitive sector of the economy is gaining momentum, maybe that’s telling. Fiscal policy also remains incrementally stimulative and inflationary. Real rates aren’t really that high: If 2% inflation is the goal, but evidence continues to show that 4% is the reality, the economy either needs more time for past rate hikes to work, or policy simply isn’t tight enough. Indeed, if underlying core inflation is now trending around 4% (somewhat higher in the U.S.), real policy rates have now moved back into positive territory, but not by a wide margin with the BoC at 4.75% and the Fed at 5%-to-5.25% (Chart 6). That is now near the slightly positive real rates seen at the tail end of the pre-COVID cycle, but that was arguably an era of disinflationary pressure and suppressed post-GFC rates that no longer exists. Cycles prior to that one (e.g., late-1990s and mid-2000s) saw real rates move into the 2%-to-4% range before the economy ultimately rolled over. That’s certainly not to say that we need to see another 200 bps of tightening, but real rates might need to drift up somewhat further through a combination of more disinflation, and incrementally more tightening. The Bank of Canada seems to agree by tightening in June. |
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Key TakeawayMonetary policy tightening takes time to work, and it is working… gradually. Keep in mind that this tightening cycle started from an exceptionally stimulative level, and the economy may have some extra buffers built in. That said, real policy rates have now crept into positive territory, which is a critical checkpoint, but it’s entirely possible that policy just hasn’t become quite tight enough, for long enough, yet. We saw the Bank of Canada give a nod in this direction when it raised rates again on June 7th; and we suspect both the BoC and Fed have some more work to do, even if the latter pauses on June 14th. For the economy, this is still a lot of tightening to swallow, and the risk of a downturn remains in place—for later this year. |