Questions? We've Got Answers 

Q1. After a strong start to the year, are cracks showing in the U.S. economy?

Resilience has been a common description for the U.S. economy over the past year. And for good reason. Despite the most aggressive monetary tightening cycle in several decades, the economy still grew at an above trend pace in 2022 and added over 6 million jobs.  

Up until recently, the Fed's actions had been narrowly felt on the manufacturing and housing sectors. However, the effects of higher interest rates are now starting to pop up in other places. Business investment was weak in first quarter GDP, expanding by just 0.7% (annualized) – a noticeable deceleration from Q4. This was largely driven by a sharp pullback in equipment spending and some softening in intellectual property products. Higher frequency data suggest momentum is likely to worsen. Real core durable goods orders – a leading indicator for equipment spending – have declined for seven consecutive months, while firms' plans to increase capital outlays over the next three-to-six months have also trended lower (Chart 1).  

At the same time, the labor market is finally downshifting. Job creation is proceeding at a health clip, but the breadth of hiring has narrowed considerably. This is consistent with some pullback in job postings. Jobless claims have also steadily trekked higher through 2023, and now sit well above its pre-pandemic average. The combination of events signals a softening around the edges, but there’s no question that the labor market remains tight in absolute terms.   

This is where things get challenging for policymakers. Tight labor market conditions are sustaining strong wage gains at levels that now more than offset the loss of purchasing power from higher inflation. This is corroborated by real disposable income holding in positive territory for the past nine months, eliminating doubt on why consumer spending is running at an above-trend pace. A cooling in spending over the late winter months has proven to be short lived. April has already ushered in a pop in higher frequency credit card spend data alongside a surge in vehicle sales. 

This returns to the theme we’ve expressed in prior quarterly updates that the consumer has been desensitized due to the high starting points on job demand, savings, and wealth relative to historical periods. Time will continue to chip away at these conditions. The data certainly reveal that households continue to slim their excess savings and increasingly rely on credit to fuel spending (Chart 2). This crutch will eventually be kicked away.  

Uncertainty is everywhere and always for forecasters. Recently the focus has been on measuring the extent that tighter lending standards from regional banking turmoil will impact the real economy. This is one crack that requires close monitoring, and our revised outlook will incorporate a downgrade to investment spending. This could deepen further depending on the outcome of negotiations surrounding the debt ceiling. So far there’s been no progress, despite the U.S. Treasury pulling forward the 'X date' to June 1st. While our baseline forecast assumes an agreement to raise the debt ceiling is reached, an 11th hour deal that frays the nerves of already-fragile market sentiment could carry more significance than prior episodes in triggering a faster adjustment in economic growth.  .

Q2. Any signs that Canadian resilience is also starting to wear thin? 

The Canadian economy also showed a great deal of resilience in the first quarter of 2023. After posting a 3.4% y/y growth rate in 2022, the consumer is likely to propel real GDP growth towards 2.5% q/q in Q1 2023 (Chart 3). Some might wonder why heavily indebted Canadians continue a spending spree in a high interest rate environment. Things aren’t always as they seem. Canada's population has surged by one million additional people in the last year. Each of those people becomes a consumer of varying degrees. Although real consumer spending grew by a steady 2% q/q in the final quarter of 2022, on a per capita basis, spending declined by 1.2% q/q over that time. 

A healthy jobs market is doing its part to keep total spending buoyant. Recent childcare cost reductions have enabled more women to enter the workforce. With firms eager to hire, economy-wide employment grew by 420k y/y in 2022 – double the average pace from 2010 to 2019. Like its American counterpart, employment income is rising faster than inflation at 8% y/y. Adding on, government transfers aimed at lessening the burden of inflation have supplemented incomes by approximately $10 bn over the second half of 2022. This 'good news' backdrop for the consumer has delayed the economic growth slowdown once again.  

It’s not a perfect picture, however. Signs exist that labour market resilience will begin to fray, particularly by the end of this year. Employment gains have been juiced by hiring in non-cyclical sectors, like government, health care, and education. In the first four months of 2023, non-cyclical employment was up 74k compared to 98k for the whole of 2022. These sectors do not necessarily capture the mood within the private sector, which more immediately captures the interest rate cycle and global developments.   

On the cyclical side, recent business surveys indicate a rapid easing in labour shortages. Last summer there were 1.2 jobs available for every unemployed person, compared to 0.8 jobs today. Firms have not only filled vacant jobs, but they also pulled down job listings that are no longer needed. Hiring has come to a standstill among firms in the professional, scientific, and technical services sector, as well as in finance and insurance. Given that most firms in Canada are expecting a recession in 2023, caution is likely to continue to set in. We estimate that the economic growth slowdown will result in approximately 70k job losses over the next year. This is a small fraction of the job losses typically seen in a recession, but with healthy labour force growth, it would be sufficient to return balance to the labour market. It also lays behind the argument that any formal recession dynamics may not carry the depth of prior cycles. Even though we are seeing a slowing in momentum and expect further deceleration, there is risk that the economy fails to slow in a timely fashion or to the satisfaction of the central bank. The population surge combined with job stability can maintain an undercurrent for housing demand and spending that could very well force the Bank of Canada off the sidelines.     

Q3. Is the unemployment cycle truly disconnected from the interest rate cycle?  

Contrary to what has been reported, U.S. labor market strength is not out of sync with the tightening cycle. Table 1 shows how the U.S. unemployment rate has responded during past tightening cycles. While no two business cycles ever behave the same, the historical analysis shows that it has typically taken about a year from the time when the Federal Reserve begins raising rates to when the unemployment rate reaches its cyclical trough. From there, it takes roughly another year for the unemployment rate to rise by a mere 0.5 percentage points. But once it gets to that stage, it keeps morphing into a recessionary spike.  

Table 1: Past Business Cycle Timings

Source: Bureau of Labor Statistics, TD Economics.

Number of Months from the First Fed Hike To:	Average	Median	2022
A trough in the unemployment rate	15	11	10 (?)
A 0.5%-points increase in the unemployment rate	26	24

How does that compare today? At 3.4%, the April unemployment rate has matched January's cyclical low. If this indeed marks the trough, its timing is roughly one year from that first interest rate hike, within the range of the historical experience. 

As discussed in question 1, if labor market indicators continue along a cooling trajectory, it is conceivable that the unemployment rate rises by 0.5 percentage points by year-end. That would place it within spitting distance of its long-run average of 4%. From there, history would suggest that it’s unlikely to come to rest at that level and a further upward push takes hold in 2024 on an echoing of negative corporate sentiment. 

How high the unemployment rate goes then becomes the only question. This cycle has the distinction of elevated job openings, even though it’s already fallen by 2.5 million from last year's highs. In doing so, the unemployment rate has drifted a bit lower. This is counter to what a long-held relationship, known as the Beveridge Curve – the inverse relationship between job openings and the unemployment rate – would predict. This is one argument supporting a shallower rise in the unemployment rate relative to historical experiences. However, even under our view of a 1.2 percentage point rise by Q4-2024, the economy will not be insulated from some pain.  

Q4. What is up with U.S. credit conditions in the wake of the regional banking stress? 

The wake of several U.S. bank failures is expected to bring tighter credit conditions, but it will be difficult to distinguish how much will be related to that unique event relative to the natural course of events of a high interest rate environment that automatically impacts risk tolerance, collateral values, and bank funding costs. For instance, the Fed's Senior Loan Officer Survey disclosed that 46% of lenders reported tightening standards for C&I loans. This has not reached peak levels of previous recession cycles, but certainly trending in that unfavourable direction. The credit impulse is slowing, placing a speed limit on consumer spending and business investment. Most estimates point to a 0.4 percentage point hit to growth from tighter credit conditions, raising the risk that GDP growth will push towards negative territory later this year. 

For the Federal Reserve, mixed messages require caution in pursuing any further adjustment in interest rates. First, it’s important to not describe lending as a single market. Long before any bank failures, credit conditions had swiftly tightened on all sorts of commercial real estate (CRE) loans (Chart 4). This side of the lending market already reflects the characteristics of past recession cycles. And as we outline in a recent report, the office sector carries the weakest fundamentals out of the four major (CRE) sectors and is far from being resolved.  

The silver lining for the Federal Reserve is that markets, so far, are not signalling concern around a broader systemic banking stress that would bring about a 2008-style hard landing. The quick response of the Fed, FDIC, and Treasury to prevent contagion has been effective. Both equities and bonds have rallied. The S&P 500 is up approximately 9% this year, while the BBB corporate yield has eased by over 50 basis points (bps) in the last two months. Our Financial Stress Index has reflected this, moving back to neutral levels (Chart 5). In the eyes of market participants, the regional bank risk has been contained. 

Q5. How do North American housing markets look heading into the spring market? 

U.S. existing home sales appear to have found a bottom on a trend basis, but there's likely to be more volatility over the near-term. With affordability near multidecade lows, home sales activity is showing an increased sensitivity to mortgage rates, with a typical lag.  For instance, a 1 percentage point (pp) pullback in the 30-year mortgage rate between early November to February, was followed by a strong double-digit sales rebound in February. However, an upswing in mortgage rates that month, contributed to a decline in activity later in March.  

On the supply side, the existing home market has improved moderately from last year's levels, but it still slim-pickings for would-be homebuyers by historical standards. The strong job market has limited any forced-sales behavior, while supply churn has been further depressed by conditions that create little desirability to move. Homeowners who locked into very low mortgage rates during the pandemic would lack an incentive to move. The economics of this would be particularly meaningful for would-be move-up buyers, who would incur not just higher mortgage rates on that decision, but also higher home prices.  

In contrast, the economics for the new home market have improved relative to the resale market. Builders are offering plenty of incentives, such as mortgage rate discounts. As a result, the new home market has moderately increased its share of the sales pie (Chart 6). The loose conditions in the new home market should incentivize more competitive price behaviour in the larger existing home market too.  Moreover, we expect tough-buying conditions to persist in the second half of this year as the labor market starts to deteriorate. These factors suggest that the positive home price growth trend that has emerged in recent months is likely to prove temporary. We expect the sluggish price performance to resume once the spring season is over.  

In Canada, home sales also found a bottom in the first quarter. This is consistent with our expectations, although the force of the rebound was not. Sales advanced at a double-digit pace in April in Calgary, Toronto, and Vancouver, albeit from very low levels. The rapid run up in interest rates had pushed sales to levels far below any reasonable long-run trend – given fundamentals like household income. This had formed the basis for our view that the market was ripe to form a bottom. However, a downshift in mortgage rates, alongside strong job and population growth may have lit a fire under demand.   

The surprise didn’t end there. Resale supply pulled back to a larger extent than anticipated in the first quarter. The same forces apply in Canada as they do south of the border. One difference is that the structure of Canada’s mortgage market creates a faster transmission of higher mortgage rates relative to the U.S. through a shorter term period before mortgage renewals must occur. However, financially stressed households have had the ability to lengthen their amortizations, weighing against forced selling dynamics. In the end, supply dynamics have returned nearly all provinces back into seller's territory (Chart 7) and pushed average prices higher. This is an important factor that will drive a significant upward revision to our near-term price forecast, with prices likely to have a double-digit handle on a Q4/Q4 basis versus the 3% decline projected in March.

This answer lies in our confidence that inflation for services will maintain a downward trend and that the Fed will demonstrate patience amidst long lags. Admittedly, our confidence in both is being challenged these days.  

As of April, CPI services inflation continued to run hot, with the 12-month change sitting just under 7%. Equally concerning, the near-term directional trend reflected by the 3-month annualized measure only looks marginally better at 5.9%. This is nearly double its pre-pandemic growth rate. Shelter inflation continues to be a culprit – accounting for a little more than half of the increase in headline inflation. However, this is not new information. The long lags on that measure were well known and the timeframe for a more convincing bend was not expected to occur until the summer. So far, the data seems to be on track. Over the last two months, shelter costs have shown some early signs of cooling, with owner’s equivalent rent (OER) and rent of primary residence (RPR) each advancing by 0.5% month-on-month (m/m), versus the 0.7%-0.8% m/m gains in the prior six months. The slowing that we are seeing in today's data is the result of the pullback in rental rates that started last year. The simple arithmetic indicates that this passthrough should continue to be a source of disinflationary pressure through this year and into 2024.

Unfortunately, the story doesn't end there. The remaining categories holding up service inflation have been less cooperative than expected.  These all fall into a category of non-housing services, also referred to as the 'supercore' (discussed in more detail here). The FOMC has more recently homed in on this component because it includes services that are heavily influenced by demand in the domestic economy. Supercore inflation is running hot with the 12-month change just under 5%. Even though the 3-month annualized trend has recently eased to 3.5%, much of this has been due to an idiosyncratic calculation of medical costs, which are less 'cyclically' driven. Removing that sub-component reveals the remainder of the categories advancing at nearly a 7% annualized pace over the past three months!  

Much of its strength is a by-product of labor market resilience, which has helped sustain meaningful upward pressure on wage growth. This is evident across a spectrum of wage measures, including the Employment Cost Index, average hourly earnings, and the Atlanta Fed wage tracker (Chart 8). In recent months, elevated wage growth has more than offset the loss of purchasing power that households have faced from multidecade inflation, resulting in positive gains in real disposable income. This has helped fuel discretionary spending, in turn, keeping upward pressure on non-housing service inflation, like transportation (+9.7%) and recreation (+8%) whose three-month annualized readings sitting well above respective pre-pandemic rates of growth. This is ultimately why economists view a cooling in the labor market as a necessary condition to slowing the inflation dynamics. But even as that happens, it can take anywhere from 9-12 months to manifest in any measurable downward pressure on wage growth – which is where the Fed's patience comes in.  

By extension, market expectations that the Fed will be able to cut rates by September certainly appears premature. It would require a far harder landing in the job market before that point, and the data doesn't support that outcome. We deem the earliest point for rate cuts to be in early 2024, provided the unemployment rate is showing a decisive upward trend by then. That would offer an argument for the Fed to gently back the policy rate off highly restrictive territory, as a caution against provoking a harder economic landing.  

Q7. Why has Canadian inflation cooled more than the U.S.? Can the BoC remain on hold?   

The interconnectedness of the Canadian and U.S. economies means that inflation rates do not typically deviate much from each other. However, recent data shows that something has changed. U.S. CPI excluding food and energy is running at 5.5% year/year (y/y), while in Canada, the equivalent measure is tracking at only 4.4%.  

Shelter costs explain roughly two-thirds of the difference between Canadian and U.S. price growth. This is mostly due to measurement differences between the two countries, with the U.S. owner's equivalent rent category capturing prevailing market rent trends with a roughly 12-month lag. The remaining one-third of the inflation deviation is coming from recreation and childcare price growth, with the latter depressed in Canada by non-market forces with daycare subsidies. When we strip out these factors, inflation in Canada and the U.S. aren't too different.  

The relative advantage in Canada has supported the interest rate pause by the central bank so far, but getting its targeted measure (the annual rate of inflation) to stabilize near 2% could become more elusive. To assess this, inflation categories that are most sensitive to wage pressure pass-through are isolated into a 'supercore' inflation metric (see report), which is running at a concerning 5.7% y/y (Chart 9). This is a reminder that the road ahead for the Bank of Canada is littered with uncertainty. Much will depend on the evolution of the labour market to soften beyond the initial fraying discussed in Question 2. Although markets are expecting rate cuts to start by this autumn, that timing is premature. Given the sturdy backdrop for inflation and labour, combined with a resurgence in housing, the earliest timing for a rate cut by the BoC would be Q1 2024. However, this requires a convincing deterioration in the job market, which is reflected in our baseline. Absent this, the BoC may be forced to raise rates again. 

Q8. Will Canadian government budget announcements contribute to inflation pressures? 

The short answer is yes. We estimate that, relative to fall updates, additional measures contained in provincial and federal budgets for this fiscal year amount to around $25 bn, or about 0.8-0.9% of GDP (Chart 10). This estimate matches what the Bank of Canada calculated in their April Monetary Policy Report, although the central bank also estimates that $25bn of stimulus will be added each year in 2024 and 2025.  

Even with the potential to fan inflation, one could argue that many of these measures were necessary. For instance, Canada trails other G7 nations in healthcare expenditures as a share of GDP, and this spending featured prominently with provinces forecasting a combined gain of 6% this fiscal year. In addition, Canada has earmarked significant funding for the clean energy transition to keep emissions targets on track and match the hefty commitments made by the U.S. through its Inflation Relief Act (see report). Even the so-called "inflation-relief measures" rolled out this budget season have been scaled down relative to prior commitments, although their timing is still not ideal from an inflation-fighting perspective. As we’ve noted in the past, government transfers are helping to keep the Canadian consumer resilient. A continuation of this trend could force the Bank of Canada to keep its policy rate higher for longer (or slow its eventual descent) relative to a situation where these measures were not deployed.

Q9. What about the global economy? What should we be watching? 

The global economy hinges on the ongoing recoveries in China and Europe.  

China 

The consumer led rebound has come in stronger than expected. It would not be surprising to have 2023 GDP growth at around 6%, particularly given the base effects from a weak prior year and the strong start to Q1 this year. Consumer mobility statistics, particularly for railway and aviation, reported a surge in passenger traffic above pre-pandemic levels, after languishing for years. But the domestic-led recovery in China may not power global growth like past expansions in China. The non-manufacturing business activity PMI is at a 10-year high, but manufacturing and import order indicators are not in expansion territory, making China's recovery less impactful for growth and inflationary pressures outside of the region.  

While the real estate sector in China is still working through excesses, we are seeing early signs of a bottoming out, leaving less threat to the consumer-led recovery in the near term. We were monitoring builders being unable to finish projects, one of the biggest issues in the sector. Authorities have focused on helping capable firms finish projects, and so in the early months of this year, we've seen an uptick in completed buildings. We are now looking for real estate investment to bottom in the second half of this year and start to recover in early 2024.  

Euro area 

In the euro area, the recovery has been powered by the service sector and consumers, as an unseasonably warm winter sheltered the region from an energy crisis and possible recession. Consumer credit conditions had improved quite a bit earlier this year as the most negative of sentiment faded from the outlook. On the business side, a similar narrative is playing out as in the U.S., where bank standards are tightening to a greater extent, and this theme is likely to continue as the ECB pursues further rate hikes and global economic uncertainty persists (Chart 11).

The ECB hiked rates in May to 3.25% and we expect more hikes to come, with the ECB to reach 4% later this year. A big challenge in Europe is inflation, even more so than the experience in North America. The service sector is running hot, pushing up core inflation (ex food and energy) to nearly 6% annualized last quarter (Chart 12). But, looking just at the core metric doesn't do justice for the pressure households are facing. Food price inflation is astronomical compared to those faced by Americans and Canadians and represents a larger share of European household budgets.  Many nations are experiencing food inflation at roughly two times the growth of the peak levels that occurred in North America, with little immediate relief in sight. This is a significant downside risk to the resolve on household confidence and can also potentially fuel social unrest if the summer months bring weather that further strains food supply and prices.  Overall, the euro area resilience will be tested again in 2023, after a very trying prior year enveloped in an energy crisis. Our forecast remains for tepid growth in the euro area, at 0.6 and 0.5 percent in 2023 and 2024, weighed down by rising living costs, higher interest rates, and diminishing fiscal support. 

Q10. How are we thinking about the U.S. debt ceiling?   

The deadline for Congress to raise the U.S. debt ceiling is rapidly approaching. Treasury Secretary Janet Yellen has stated that the U.S. government could run out of cash by early June, an event that would risk a debt default and put the economy and America's safe haven status under threat. Financial markets are already expressing nerves, with securities that insure against the risk of default surging to their highest level in history (Chart 13). Although a default is seemingly unthinkable, the current brinksmanship in Washington poses a larger threat to the economy than the 2011 episode, which resulted in the U.S. being stripped of its top credit rating by one of the rating agencies.

Why? Starting points matter. The period in 2011 did not have the characteristics of today's markets that are already heaving under the weight of 1) high interest rates, 2) recession expectations and 3) regional bank volatility. Markets are wary of the "next shoe to drop", and political brinkmanship can create greater market repercussions than past cycles.  

Layering on top of these economic concerns, is a different political backdrop than in 2011. Party majorities are thinner in both chambers of Congress now than they were in the early 2010's, which can make reaching a consensus more difficult, even within one party. This was illustrated by the fact that House Republicans only managed to pass their recent 'Limit, Save, Grow Act' by a margin of 2 votes, despite having a 9-member majority. Given the stakes of a potential default and the relatively thin margin for error, markets continue to take a cautious approach to the present round of negotiations. 

Although there is a multitude of ways for the current negotiations to be resolved, the path forward can be summarized as follows. The best-case scenario is that an agreement is reached in the coming weeks to raise or suspend the debt limit for a year or longer. The impact on financial markets and the economy would be expected to be benign in this scenario. The second-best scenario would see the debt limit raised/suspended until late summer, when the regular budget appropriations process occurs, at which time a timely agreement is reached. While financial markets would prefer a definitive near-term solution, the prospect of any deal being reached would likely be enough to keep the impacts modest. Regardless of the type of deal reached, the closer to the X date it is, the greater the risk to financial markets and the economy, with the impacts expected to become exponentially larger in the final days. The third and worst-case scenario is that the United States defaults for the first time in history, pushing the economy into a recession in the near-term and creating structural headwinds in the long-term (structural risk premium increase, reduced international standing, etc.). The economic impacts of even a short default would be severe, with potentially hundreds of thousands of job losses. 

Although markets are taking out insurance on the worst-case scenario, there is still a glimmer of hope. The U.S. Treasury has about $200 bn in cash on hand and June is typically a month that sees moderate flows into the Treasury. This has caused many to push out the expected X-date into July. Currently, equity markets have not priced any risk of U.S. government default. Ditto for the bond market in general. We note that investors have been wise to avoid buying debt that is set to mature close to the X date, but trading in Treasuries with longer horizons has been normal. This implies that investors think there may be some temporary stress, but that the issue won't persist. This is also our baseline view. We have always assumed that a deal will be reached, likely at the eleventh hour, which doesn't necessarily mean smooth sailing. A brief drop in equities and flight from Treasuries and the USD may occur as the X-date nears, but history shows that this is a risk that should be short-lived.