Canadian Quarterly Economic Forecast

Global

• Compared to our December forecast, we have marked down global growth 0.8 percentage points, taking it to 3.9% (from 4.7% previously) in 2022. The outlook for 2023 has been eased slightly to 3.4% from 3.7%.  
• The war in Ukraine and accompanying shock to energy, food and other commodity prices is the main factor behind the downgrade to the European outlook. Softer growth through the winter months amid the spread of the Omicron COVID-19 variant has also weighed on the handoff for 2022. 
• Energy and wheat prices have surged in response to the conflict in Ukraine, adding fuel to the inflationary fire. Moreover, sanctions on Russia and export controls add another layer of disruptions to global supply chains. European economies will face the brunt of the economic effects, but the shock is sure to reverberate around the world. 
• However, there are already signs that governments will try to cushion the impacts. This adds an element of upside uncertainty to the downgraded outlook via the potential for large fiscal responses among E.U. member states. Roughly 200 billion euros from the E.U.’s Recovery and Resiliency Facility remain available for potential deployment to households and businesses, while other countries, like Germany, have already announced substantial increases in defense spending.  The impacts of both initiatives would lag relative to the immediate shock underway but begin to manifest by the second half of the year.  
• Among emerging markets (EMs), food is significant share of the consumer basket. The sharp move higher in food prices will cut deeply into real disposable income and dent domestic demand. Moreover, higher inflation and the associated rate hikes in advanced economies could lead to capital outflows, putting currencies under pressure and further increasing borrowing costs. That said, commodity exporters will benefit from both higher prices and potentially new customers as purchasers seek to limit exposure to Russia.

United States 

• After the strongest annual average growth in nearly 40 years (5.7%) in 2021, U.S. economic growth has shown clear signs of slowing at the outset of 2022. Real GDP growth in the first quarter of 2022 looks to come in close to stall speed (0.6% annualized). Underneath the surface, domestic demand – spending by American households and businesses continues to grow at an above trend rate, but supply chain challenges and weak foreign activity are weighing on economic growth. 
• Inflation, which had already risen to worrisome levels, will move even higher because of the war in Ukraine. Higher food and energy prices will reduce consumer’s purchasing power and slow growth in personal consumption expenditures – the biggest component of GDP – this year. 
• The good news is that the labor market has continued to perform very well, with job growth surprising to the upside and showing little signs of deceleration in recent months. Labor demand is looking strong, with job openings still at very high levels. We expect continued hiring o push the unemployment rate lower, moving below its 3.5% pre-pandemic low. A recent increase in the labor force participation rate is another source for optimism, indicating that the scaring that occurred because of the pandemic may finally be healing.
• Business investment is another bright spot, accelerating at the outset of the year and likely to remain healthy over the course of this year. High energy prices will be a boon to American energy producers who are likely to increase investment to raise production. 
  Overall, we expect solid annual average economic growth of 3.2% in 2022, slowing to 2.5% in 2023.      

Canada 

• Canadian economic growth surprised on the upside in the final quarter of last year, growing by 6.7% annualized and providing a strong hand-off into 2022. Prior to the invasion of Ukraine, the biggest factor for the outlook was the restrictions on economic activity that took a deeper hold in January to fight the spreading Omicron wave. The Canadian economy looks to have been resilient to that wave and bounced back quickly as restrictions were lifted.
• The commodity price shock that has since resulted is now set to slow some of that momentum. While higher prices for producers (both energy and food) will offset some of the losses, higher inflation will eat into purchasing power and slow consumer spending in the first half of 2022. The good news is that households have the benefit of a white-hot job market. Coupled with greater pent-up demand for services (as Omicron-related lockdowns were harsher than most other countries) and more delayed business reopening, there is ample room for an ongoing expansion. Spending should remain resilient and accelerate as the price shock dissipates.
• Input costs remain elevated for businesses, but some will benefit from the higher commodity prices, creating regional variation. In addition, the rising cost structure may compel or accelerate investment within Canada. Prior to the Ukraine war, firms were clearly signalling a willingness and ability to spend after lagging peer countries despite several quarters of robust profit growth.
• Inflation will pick up in the near-term, as food prices and energy costs drive headline figures. It should gradually slow over the course of this year, but with tight labor markets and limited slack, it is likely to remain above the 2% mark until mid-2023.
• All told, we expect annual average real GDP growth of 4.0% in 2022, slowing to roughly 3% in 2023.     

Financial 

• Following its hike in March, the Federal Reserve is likely to opt for a 50 basis point hike at its next meeting, and follow with three more rate hikes this year, pushing the fed funds rate to 1.75% by the end of 2022 and 2.25% by the middle of 2023. 
  For the Bank of Canada, we have also penciled in a 50 basis point hike at its next meeting and four more rate hikes over 2022, ending the year at the same 1.75%.The overnight rate is expected to peak at 2.0% in early 2023.
• It’s natural to wonder how the Ukraine war might alter the path.  Fewer rate hikes would likely require evidence of a much slower domestic growth pattern taking hold due to the erosion in financial conditions and sentiment. Worrying signs of financial contagion can also do the trick. Likewise, should geopolitical risk premiums recede and inflation stay elevated, the central bank would opt to speed up the rate normalization timeframe.
• Canada’s job market has proved exceptionally robust. It’s possible the Bank of Canada will opt for more rate increases or further 50 basis point hikes at subsequent meetings, given the asymmetry of an economy in excess demand relative to an exceptionally low policy rate. The Federal Reserve has signaled higher rate expectations than we have penciled in, but we suspect this is to anchor market inflation expectations. Both central banks could run the risk of moving too fast and too far given they are on the backfoot with inflation and had indicated an intention to simultaneously reduce the size of their balance sheet.
• Expectations for rising policy rates, the start of Quantitative Tightening (QT), and elevated inflation should continue to push up government bond yields. This is already evident at the short and long end of the curve, but this normalization process remains incomplete. The 10-year yields should not just cross the 2% threshold (as already evidenced) but continue to edge up as the year progresses. 
• Movements in the Canadian dollar have been disciplined. Despite the surge in oil prices, the loonie has remained range bound between 76 – 80 cents over the past four months, due to lower commodity sensitivity from more muted passthrough relationships to higher investment. As a result, most of the movement occurs through two channels: risk sentiment (which is loonie negative) and U.S.-Canada spreads (loonie positive to neutral). As time passes and war risk sentiment recedes, the loonie should appreciate slightly relative to the U.S. dollar. There is also room for the euro and pound to appreciate, as these currencies are trading below long-term fair value. We are less optimistic on EM currencies relative to the USD, given weakness in their respective economic recoveries.