More pain to come, as central banks draw closer to the end of a historic hiking cycle
By Claire Fan, Economist, RBC
- The Bank of Canada and U.S. Federal Reserve last year embarked on one of their most rapid rate hiking cycles since the 1980s, to tame rapidly accelerating inflation pressures by slowing the economy down.
- Inflation rates in both countries have now dropped to levels that do not require immediate additional intervention from the central banks.
- Households have so far continued to spend at record levels. But there are signs of slowing of economic activities underneath the surface.
- Policymakers won’t be convinced that lower inflation is sustainable until demand softens further. They will also be willing to hike rates again if inflation re-accelerates.
- Against that backdrop, we think a bumpy landing is still the most likely outcome for both economies, where GDP growth contracts slightly later this year and unemployment rates drift higher.
Robust economic data brought sunny days for equity markets over the summer as recession fears eased.
Inflation has shown further signs of slowing—albeit in varying degrees across regions. That’s reducing the urgency of central banks to push interest rates higher even as economic growth continues to be stronger than expected. Despite improved market sentiment, yield curves are still steeply inverted on the expectation that the economy will soften and central banks will need to shift back to interest rate cuts in 2024 and beyond.
Households in large parts appear to be weathering the interest rate increases better than previously expected, with spending especially on discretionary services holding strong. But elsewhere, signs of weaknesses are emerging. Banks in the U.S. continue to report tighter lending standards and slower commercial & industrial loan demand—a sign businesses are growing more cautious. Similarly, imports of industrial machinery and equipment in Canada, a leading indicator for business investment activities have been flagging since spring.
Slower inflation trends to-date has been helped by lower energy prices, which may not last. Oil prices have largely been moving higher in recent months despite concerns about softening demand in China. Central banks have little influence over global commodity prices. But even excluding energy, the looming question is just how long softer “core” inflation prints can be sustained against a still-resilient macro backdrop. And while central banks would prefer not to hike interest rates further, they are also clearly willing to do so if needed to bring inflation fully and sustainably under control.
Easing global inflation trends allow central banks to hit pause
It’s hard to dismantle just how much of slowing inflation pressures to-date can be attributed to tighter monetary policy, and how much to easing supply side constraints. Regardless of what drove it, price pressures have been easing broadly from acute levels in 2022, with headline CPI dropping to around 3% in both Canada and the U.S. over the summer.
Central banks’ core inflation measures, designed to give a better gauge of more persistent underlying inflation pressures (aside from food and energy price volatility that central banks have less control over) have also been decelerating. According to those measures, however, domestic price pressures are proving a bit more persistent in Canada than in the U.S. The 3-month annualized rate of increase in the Federal Reserve’s preferred “supercore” (core services inflation excluding shelter) measure eased to ~1 1/2 % in the U.S. in June and July. Meantime, month-over-month growth in core inflation measures in Canada are running well-below year-ago levels, but have been stuck in the 3.5% - 4% range since late 2022.
The U.S. Fed and the Bank of Canada moved in lockstep in July, raising policy rates by 25 basis points – bringing total increases for this hiking cycle to 475 bps in Canada and 500 bps in the United States. Interest rates are now at levels that central banks view as sufficient to slow the economy and inflation over time, and further changes will depend on the evolution of economic data and observed inflation pressures. The impact of rate hikes to-date have not yet been fully felt and will continue to ripple through economic growth data and labour markets with a lag. Central banks are growing increasingly wary about the risks of overtightening. That’s especially true in Canada, where economic data is already starting to show some weakness, especially in the labour markets. In that context, most central banks appear to be leaning towards a ‘hopeful’ pause in the current hiking cycle.
The bar for further tightening in monetary policy is a high one. Absent a large reacceleration in price pressures, we expect both the BoC and Fed to leave their policy rates unchanged for the rest of 2023. And we don’t expect a shift to rate cuts until the second quarter of 2024 for the Fed; and the second half of next year for the BoC.
Canadian economy softening despite record population growth
Surging population growth has complicated efforts to track the health of the Canadian economy. Canada added nearly 230,000 new consumers aged 15 and older to its population in Q1, giving a sizable boost to consumer demand. On a per-person basis however consumer spending has actually been softening. And there are signs that headwinds from higher interest rates are having a more significant impact on household purchasing power. Though GDP edged higher in Q2 (according to preliminary estimates), it nevertheless declined in June (-0.2%.)
Meantime, early signs of softening in labour markets suggest further weakness is still in the pipeline. Employment growth may have risen in Q2, but it edged lower in two of the last three months. And the combination of a drift downward in labour demand (as job openings trend persistently lower), and upward in labour supply (still-booming population growth) has begun to push the unemployment rate higher. Canadian labour market data is notoriously volatile. But a 0.5 percentage point increase in the jobless rate over the last three months to July is the biggest jump, outside of the pandemic, since the early days of the 2008/09 recession.
Spending on discretionary services, the sectors most affected by pent-up demand following the pandemic like restaurants, remains firm. However, growth in real spending (controlling for high inflation) has begun to flatten out. And spending on goods is softening too. Retail sale volumes in Q2 are tracking 2% (annualized) below Q1 levels. And imports of consumer goods are running almost 10% below where they were last fall.
Household purchasing power is already being stretched by higher prices and rising debt servicing costs, leading to rising delinquencies in credit card and auto loans. Until now, firm labour markets helped cushion the impact on consumer spending and the broader economy. But high household debt levels mean Canadians are now more vulnerable than ever to a long-expected softening in labour markets.
A bumpy landing is still more likely in the U.S.
In the U.S., broadly easing inflation pressures are playing out against a resilient consumer and labour market backdrop. Recent data releases for the month of July, including robust gains in retail sales and industrial production have suggested a strong start to the third quarter. This has increased talk of a possible “soft-landing” for the U.S. economy, where inflation slows to the Fed’s 2% objective without a significant deterioration in labour market conditions or an increase in unemployment.
We still think that’s unlikely. Well-anchored, longer run inflation expectations have probably played a bigger role in the moderation of inflation trends than is commonly appreciated. But the Fed isn’t likely to view slower inflation growth as sustainable without softer consumer demand and labour markets.
And there are still reasons to expect more weakening in economic activities in the pipeline for the U.S. Large amounts of excess savings that were built up during the pandemic are now largely depleted. Household liquid assets, including cash and time deposits have also been falling outright in every quarter since Q1 2022. And headwinds like the restart of student loan repayments in October still loom over many households. High interest rates have made borrowing to support current spending increasingly inaccessible. To-date, growth momentum in the U.S. economy has been firmer than expected and GDP is likely to post another increase in Q3. But early signs suggest there’s more softening in economic activity to come. And continue to look for GDP growth in the U.S. to slow down more significantly later this year.