Record high gasoline prices in both countries will drain purchasing power and slow spending. The $1 jump in U.S. regular fuel prices this year to record highs (a near 30% gain) is estimated to carve real consumer spending by 0.7%, though high household savings will help soften the blow. North of the border, the jump in fuel prices this year could spur a somewhat larger hit for shoppers. Canadian drivers haven't been helped by the loonie's rare decoupling from oil prices due to strong safe-haven demand for greenbacks and expected faster Fed tightening.
Thankfully, North America's economy showed decent resilience before the war, mostly weathering the record number of coronavirus infections at the turn of the year. The resilience reflects high household savings, inventory re-stocking, and still-low interest rates. In addition, Canada has posted a string of current account surpluses in the past year amid improved terms of trade, while the U.S. opted for no new measures to address Omicron. In the fourth quarter of 2021, real GDP grew 6.9% annualized in the U.S. and nearly as much (6.7%) in Canada. For the latter, strong GDP figures at the start of the year, despite capacity curbs, point to growth of 4.0% in Q1. Canada is now rapidly easing restrictions, allowing employment to rebound 336,600 in February, pushing further above pre-virus levels. This chopped the unemployment rate by a full percentage point to 5.5%, the second lowest level in 50 years!
Still,the fallout from the war drove a one-half percentage point markdown of our Canadian growth call to 3.5% this year and to 3.0% next year. This is still above potential growth (thought to be less than 2%), though subject to further downgrade if the war spreads beyond Ukraine's borders. Meantime, oil-heavy Alberta will lead the country with 5% growth this year, as it looks to use now gushing fiscal revenues and a return to budget surpluses to cushion the hit to consumers and businesses.
We also cut our U.S. GDP forecast by one-half percentage point to 3.0% this year and trimmed next year's call to 2.3%.Following a hefty inventory build last quarter, the economy looks to expand less than 2% annualized in the first half of the year, before picking up in the second half, assuming no further damage from the war. Even with slower growth, the unemployment rate is expected to edge down to 3.4% later this year, the lowest since 1969. Businesses have been on a hiring binge, lifting nonfarm payrolls by more than half a million on average in the past three months, or three times the norm. The NFIB small business survey, however, suggests job growth will downshift due to the war's impact on confidence.
Will the war chill Canada's overheated housing market? It should, so long as it doesn't derail the Bank of Canada from normalizing policy. A cool-down of current feverish conditions would be welcomed. Benchmark prices posted record gains on both a yearly (29.2%) and monthly (3.5%) basis in February. Even though prices are far detached from family income in many areas, bidding wars remain relentless, with the country posting the second-best February sales on record. Toronto's prices are up 36% y/y, and prices are rising even faster in some other areas, such as Brantford, where the benchmark house costs 47% more than a year ago (and 7% more than just last month). Higher interest rates will eventually take a toll, notably on investors who are now the fastest rising share of buyers. But the main threat is that prices could keep climbing at an unsustainable pace, before higher rates have a chance to pull the market gently down to earth. Solid job growth and a rebound in immigration will provide support, but demand is likely to weaken and price growth simmer down. The energy and resource producing provinces of Alberta, Saskatchewan, and Newfoundland and Labrador should outperform the national market. Not only have they mostly avoided the explosion in house prices in the past two years, and thus remain affordable, they stand to benefit from soaring prices of oil, wheat and potash. Calgary’s existing home sales hit a record for the month of February and prices accelerated 16% y/y.
Central Banks Gird For Battle
Neither the Fed nor the Bank of Canada imagined two years ago that inflation would overshoot their targets by such wide margins. And, neither likely thought two months ago that they would need to fight a war on inflation with one arm tied behind their back due to a real war and its uncertain effect on the economy. Both will need a “nimble” approach to decision-making (and some luck) to get inflation under control without short-circuiting the expansion. Neither central bank believes the war will be an obstacle to tightening. The Bank pulled the rate trigger on March 2, for the first time since 2018, while the Fed moved on March 16. Both central banks intend to stick to the normalization path this year, and neither has ruled out hefty increases to quell inflation if needed, even at the cost of a recession, according to Powell. The Fed Chair recently said it may need to move "more expeditiously" to normalize policy, while the Bank's Deputy Governor says it "is prepared to act forcefully" to control inflation. We expect the Bank to move in 50-bps steps at the next two meetings, before switching to a more measured pace that takes the policy rate to 2.5% by next spring. The Fed looks to hike in 50-bps steps at the next two meetings as well, eventually taking the midpoint of the fed funds target range to 2.88% by mid-2023. Both end-points are at the high end of a neutral range, though the risk is that an overshoot will be needed to douse the inflation flames. Only if the war depresses growth more than it raises inflation will either central bank take an extended pause on the normalization trail. In any case, achieving a coveted soft landing will be bumpy with plenty of turbulence along the way.
As for quantitative tightening, we expect both central banks to start shrinking their balance sheets in the weeks ahead. The Fed is planning (after a three month phase-in period that is likely to start in May) to not reinvest up to $95 billion of maturing Treasury notes and mortgage bonds, which is about double the pace of runoff in the 2017-19 period. The Bank of Canada plans to go full-steam ahead with portfolio runoff. Neither central bank intends, for now, to sell assets in the secondary market, for fear of driving long-term rates up too sharply.
As the policy screws tighten, we'll have a close eye on the slope of the yield curve, which is probably the single best predictor of a downturn. The current spread between 10- and 2-year rates has narrowed considerably, even as long-term rates have jumped to their highest level since 2019. The market continues to price in a series of central bank rate hikes to corral inflation, which is lifting the mid-section of the curve. If the Fed needs to move more aggressively than the market anticipates, the yield curve will invert, flagging a potential downturn.
It's hard to end our discussion on a cheerful note. Perhaps the best thing we can say, for now, is that if inflation moderates as expected, and the war ends soon, and the pandemic remains in check, the darkest clouds will begin to lift. While we will still see slower growth this year, at least the expansion should continue at a decent pace.