Questions? We've Got Answers 

Q1.  Give peace a chance: how has the global outlook evolved? 

• The global outlook has soured since last quarter's update. The war has provided another updraft to commodity prices, deepening supply reliability concerns. In Europe – a major importer of energy products – higher prices are acting as a de-facto tax on households and businesses. As expected, European states continue to look for ways to offset the crunch on households, with some unveiling multi-billion-euro support packages. How the governments will pay for these programs varies greatly. In Germany, authorities are set to increase borrowing by roughly 40 billion euros to offset the economic effects of the war. Italy will up the rate on a windfall tax introduced in January on energy firm profits to fund their support program. 
• After only a brief reprieve, more supply chain disruptions have materialised. A stoppage in production at several German auto manufacturers due to an inability to import bespoke wire harnesses from Ukraine captures the new challenges. Suppliers' delivery times across the euro area are lengthening once again, giving back the marginal improvements that took hold through February. 
• Offering a buffer to the war's economic impacts, the service sector is getting a post-Omicron lift, particularly in major tourist destinations. 
• Moving forward, the resilience of consumers will be tested as the rapid rise in living costs erodes real incomes. Adding to the challenge is a more hawkish monetary policy outlook that will add to debt servicing costs. Despite pockets of economic strength, recent events are taking a heavy toll on consumer sentiment, which can be expected to impact expenditures (Chart 1).  
• Apart from the war, the ongoing economic slowdown in China is forcing a rethink of global growth prospects. April data showed a slowdown in export growth as rising inflation and a rotation in consumer spending towards services in advanced economies dents goods demand, while Chinese imports were flat for a second consecutive month. Moreover, signs are building that the ongoing COVID containment measures in China are impairing domestic demand as April retail sales contracted on a year-over-year basis for the second consecutive month. And, the official services PMI readings have been signaling contraction for March and April. 
• The combination of Europe's energy-import dependence and other economic links to Ukraine and Russia, along with export ties with China (particularly in the case of Germany), leaves the region vulnerable to more stagflation forces relative to North America as we head into the second half of this year.  Indeed, growth in the Euro Area is likely to register slightly below 3% this year, whereas expectations prior to the war were for a 4% expansion.

Q2. Has the impact in Canada and the U.S. been different?

• For both the U.S. and Canada, the impact of the war has been most apparent in consumer inflation data. The combination of higher food and energy prices has pushed measures of headline inflation to 8.5% and 6.8% y/y in the U.S. and Canada, respectively. Food and energy have contributed to nearly half of that increase. Like Europe, the inflationary impulse has acted as a tax on households, eating into disposable income and likely leading to some curtailing in spending on discretionary items over the near term. From the U.S. perspective, recent surveys have started to corroborate this narrative, with households showing that they plan to cut back on dining out, cancel a vacation or even delaying purchasing a new house or car if current price pressures persist. 
• Luckily, labor markets on both sides of the border remain incredibly tight. This has led to an acceleration in recent wage pressures, buffering some of the erosion in spending power, which differs from the European experience. Wages are up 5.5% y/y in the U.S., though have lagged at 3.3% y/y in Canada. Households also maintain significant excess savings as another layer of protection. However, at the end of the day, higher rates coupled with elevated price pressures will slow spending. In fact, monthly U.S. consumer spending data has already shown early signs of goods spending moderating, with outlays on motor vehicles, household furnishings, and clothing & footwear all receding in March. 
• This isn't a bad thing. It's necessary for domestic demand to ease its foot off the peddle to restrain rampant inflationary forces. Unlike Europe, the price metrics in Canada and the U.S. have shown a broadening in price pressures outside the food and energy sectors for some time. 
• U.S. spending on services has outperformed as easing COVID restrictions facilitates some normalization in consumption patterns. Canada has lagged due to longer and harsher health measures over the winter months, but a similar pattern is now playing out. The common thread between both economies is that if higher prices force consumers into making tough spending decisions over the coming months, households will likely prioritize services over discretionary goods spending. 
• Lastly, both Canada and the U.S. are net producers of energy commodities, and this creates another layer of economic buffer. However, it does fuel more regional variation. For example, while many businesses are faced with higher input costs, firms in the oil and agricultural & mining sectors are all reporting a windfall. Within Canada, this should continue to support employment growth in commodity producing provinces (such as Alberta). The impact is also evident within provincial budgets, where rising tax revenues in commodity-focused provinces are dramatically improving their fiscal outlook.       

Q3. Why has Canada recently outperformed the US? 

• In the first half of this year, Canadian economic growth will be within a 3% to 6% quarterly range, compared to very little growth in the U.S.). Both economies were estimated to be in excess demand at the end of 2021, indicating that Canada will push into deeper territory. This is surprising considering the economy has sustained broader and more stringent COVID-related restraints relative to its southern neighbor.
• One key differentiator to keeping these economies neck-and-neck has been Canada's outperformance in job growth and its success in incenting workers back into the labor force at record numbers for those aged 25-54. In Canada, the labour force participation of this core-working age cohort has risen 1.1 percentage points (to 88.4%) relative to its level prior to the pandemic. In the U.S., by contrast, the labor force participation rate among the same age group was still down 0.6 percentage points in April (at 82.4%). Canada already had a lead in labour force participation prior to the pandemic, which has since widened. 

• There is a longstanding pattern in the source of economic growth coming out of downturns. Canada tends to rely more on growth in employment in driving output gains, whereas the U.S. tends to reflect larger increases in productivity (GDP per worker) (Chart 2). While this has in the past helped the Canadian economy return to full employment faster, it is not necessarily a positive from a longer-term prosperity perspective. Gaps in labour productivity between Canada and the United States have tended to widen around economic cycles. 
• There is also a sense that Canadian households may have more pent-up demand relative to the U.S. when it comes to services and, potentially even goods.
  • In Canada, consumer spending on goods grew at a 5% annual pace in 2021. Comparatively, goods spending in the U.S. was much higher at 12% – nearly four-times the average annual pace experienced in the decade preceding the pandemic. With spending on goods having overshot by such a greater extent than that of Canada, there is less impact in the forecast from the goods to services rotation. 
  • In addition, Canada likely has more near-term tailwind in service spending. Over the last two years, services spending has only grown at a 3% pace (quarterly annualized), related in part to broader and more extended government restrictions. The current year is shaping up to be a recalibration, with services spending expected to run at roughly a 5% pace, as goods spending turns in a more modest 1% rate.

• A third element is that U.S. government spending is detracting from growth this year. In contrast, Canadian governments continue to stimulate the economy (detailed further in question 10). We estimate that net new spending announcements in provincial and federal budgets will add roughly half a percentage point to real GDP growth within an economy that already has more tailwind relative to the U.S (Chart 3). For 2022, government spending in Canada will grow at a robust 3.2%, versus little to no growth in the U.S. 
• Lastly, the countries have behaved differently when it comes to housing demand and construction despite parallel moves in interest rates. Residential investment in Canada carries two times the economic weight relative to the U.S. This naturally makes the growth dynamics within Canada more vulnerable when housing sentiment deteriorates. However, we have written previously on Canada's resilience, in part because of significant population growth and the many layers of macroprudential rules that mitigate the immediate risk that typically stems from sharp movements in interest rates. All told, residential investment in the U.S. is estimated to detract 0.1 percentage points from growth dynamics in the first half of this year, versus a 0.4 percentage point drop in Canada.   
• Finally, Canada stands to benefit from growing demand for its exports. Exports make up about 30% of Canadian GDP, with the export of goods accounting for 80% of that trade. We are expecting significant export growth over the next two quarters with demand for Canadian raw materials and manufactured products set to surge. This has already played out in recent data, with Canadian merchandise exports to the U.S. having risen by  6% (nominal $, average) in the first three months of 2022. Over that same time, Canadian imports from the U.S. are effectively unchanged. Given Canada’s role in filling the commodity supply void caused by the Russian invasion of Ukraine, this is a trend that is expected to continue over the coming months. . 

Q4. How has the sand shifted under supply chains? 

• The first wave of supply chain issues was broadly dispersed across the globe, as pandemic restrictions forced closures of producers and an abrupt stoppage to transportation links. The restrictions were then followed by an unprecedented rise in durable goods demand (primarily from the U.S.), leading to a supply-demand mismatch. Containers were stranded in locations where they weren't needed, while the auto sector lamented a tremendous underestimation of the need for semiconductors.
• The supply chain pressures have since become more localized and nuanced. North American automotive production is rebounding from the lows last year but is still coming from behind. U.S. manufacturers in general indicate better supplier delivery conditions, as ports have increased capacity (through longer operating hours). Most importantly, goods demand in advanced economies has started to wane as the rotation to services spending gains steam. The shift in demand has been a necessary condition to taking pressure off manufacturers and logistical networks. This move will also improve resilience going forward, as additional shocks will affect a smaller share of the consumption puzzle, limiting the economy-wide inflationary impacts.  

• That said, the dual shocks in Ukraine and China present a renewed threat to global economic linkages. As previously noted, the former has already forced temporary shutdowns at European automotive manufacturers. Across the euro area (and in Germany in particular), delivery times are lengthening again, while input cost inflation accelerates (Chart 4). 
• Moreover, a few product categories are standing out as facing a substantial crunch. Ukraine was a major producer of neon gas – a key input in the production of semiconductors. Firms held reserve stocks of the gas prior to the war, but the longer the conflict continues, the more desperate the search for alternative sources will become. 
• The start of the war also saw wheat prices surge as Ukraine and Russia are major global exporters. The risk of another move higher in prices looms as U.S. fertilizer prices are now up over 70% since last May and roughly 170% since 2019. Prices have surged in tandem with natural gas costs and worries about mineral supplies from Russia and Belarus. Reduced usage of fertilizer to control costs risks smaller agricultural yields going forward, reinforcing the inflationary cycle in food prices.  
• One supply chain influence that hasn't changed as much is China's commitment to zero-COVID. Although the country has mitigated production work-stoppages relative to the peak of the pandemic, domestic policies continue to create friction. Reports of logistical challenges have led to lengthening supplier delivery times and growing stocks of finished goods. Ports within China are once again facing backlogs. 
• However, this time around, some companies have been able to adjust. Vietnamese exports have been remarkably robust, suggesting some global demand substitution is occurring amid Chinese lockdowns. When combined with a softening in the demand for goods within advanced economies with the rotation towards services, the aggregate impact from supply chain disruptions should be more modest than before.  

Q5. Stagflation? I read the news today, oh boy… 

• Reading the business press these days can certainly raise anxieties: "The global stagflation shock of 2022: how bad could it get?" – FT, "Hi, Stagflation" – Forbes, "Cash is the Only Winner in a Market Gripped by Stagflation Fear" -BNN. 
• Stagflation is a term often used these days, but is not one that comes from economic theory, with a broadly agreed upon definition. The term was coined in 1965 by the UK's Chancellor of the Exchequer to describe the UK's period of high unemployment and high inflation. 

• The concept arose because that period broke the Keynesian mold that there was an inverse relationship between unemployment and inflation – i.e., when unemployment was high, inflation was low, and vice versa. Its use to describe the situation today is paradoxical. Unemployment rates in the U.S. and Canada are at indisputably low levels, while inflation is high, precisely as Keynesian economics would predict (Chart 5). Now some interpret the "stag" in stagflation as low economic growth – and indeed growth in the U.S. is looking quite soft in the first half of the year. However, it is coming off a very strong expansion at the end of 2021 and is being weighed down by a normalization in the pace of inventory building and drag from net exports. Underlying domestic demand, while more modest than the heady days earlier in the recovery, is still resilient and running above trend.  
• We also expect inflation pressures to ease in the coming quarters through a combination of lower commodity prices, base-year impacts, tighter monetary policy and capacity constraints on growth easing demand pressures in many areas. In Canada, headline CPI is expected to peak on a year-over-year basis at close to 7% in Q2, and ease to about 5% by Q4 – still well above the Bank of Canada's target. Similarly, U.S. CPI inflation likely peaked in Q1, and we expect it to ease slightly, but remain elevated at 6.3% in Q4 2022, and return to the Fed's comfort zone by the end of 2023.
• Given that inflation will be stubbornly high despite decelerating, the word stagflation may remain in the media for some time, particularly as the economic drivers normalize to growth patterns closer to (and even below) 2%. However, we prefer to stick with the traditional application that requires rising and higher unemployment. This is the true measure of risk to the economy. 

Q6.  Are inflation expectations at risk of becoming unanchored?

• Given that inflation is running at multi-decade highs around the world, it is surprising that expectations over the medium to long-term have remain reasonably anchored. Certainly, we have seen surveys of businesses and consumers pointing to 3%+ inflation over the next two years, but after that, the belief that central banks can rein in inflation remains strong. Market pricing shows inflation expectations over the 5- to 10-year horizon stable at around 2.5% to 3%, above the average since 2015, but in line with average expectations before that period. 
• Market pricing for U.S. inflation over the next 5 years does not strongly disagree with the Federal Reserve's projections from March. The central tendency of FOMC members at the March meeting had inflation above 3% on average over the next 3 years.
• This year's run-up in inflation expectations has coincided with a substantial increase in expectations for the federal funds rate, weakening financial conditions in the bond and equity markets, and a downgraded growth outlook in Europe and China. Our interpretation is that markets are adjusting to two factors: (1) a weaker external environment than expected, and (2) a realization that monetary policy will need to be tighter than previously expected. As these dynamics unfold, it becomes a circular process that helps to anchor long-run inflation expectations. There’s no getting around the requirement that economic growth must slow below the trend pace to mitigate the inflationary risks.  

Q7. Will central bank rate hikes tip the economy into recession?  

• Based on several key forward-looking data or risk metrics, an imminent recession is not forthcoming. The yield curve is positively sloped, indicators such as ISM indices are firmly in expansion territory and the labor market is exceedingly tight. But, perhaps the greatest threat to the cycle at this time is the increased speculation of recession within the media and business circles that can negatively influence spending behaviors and enhance market volatility, setting in motion the dynamics that are least desired.
• History is filled with examples where central bank interest rate hikes pushed the economy into recession. There is certainly an ever-present risk that the Fed's rapid rate hike cycle over the coming months will invert the yield curve on a persistent basis, as market participants signal their unease with the economy's resilience. 
• Central bankers are walking a tight rope between ensuring the economy slips below trend growth to cool inflation, while simultaneously trying to prevent an outright contraction. With trend growth estimated to be close to 2%, the margin for error is incredibly thin. 
• To cool the economy, rates will be moving significantly higher in a relatively short period of time. Market pricing currently has the Fed raising rates by 250 basis points this year alone, compared to the four years it took the FOMC to lift rates by 225bps over the previous tightening cycle! Put differently, rates are on track to move from today's environment of being incredibly accommodative to outright restrictive by year-end. Given the lags in the transmission of interest rates through the broader real economy, policymakers will not be leaving sufficient space between rate hikes to assess the impact. "Space" is particularly important considering that the neutral rate central banks are marching towards is an estimate of an unobserved variable. It is generally only known once it's been past based on the degree of economic weakness. All this leaves a higher likelihood of a policy error that can manifest into a recession. 
• Much will need to work in the Fed's favor, but a recession is not a forgone conclusion. American households have an estimated $2.5 trillion in excess savings and a 30% rise in net wealth from pre-pandemic levels that will take a lot more than a stock market correction to unwind. Job demand must necessarily slow to mitigate wage-push dynamics on inflation. But here too a cushion exists as the dynamics reverse, given that employers are currently looking for 1.9 times more workers than are available. And, this cycle still contains pent-up demand for services, which is unusual to other business cycles. 
• However, let’s entertain the notion that this plane won’t hit a soft landing. The word ‘recession’ is loosely thrown around, but rarely appropriately defined by the analysts using it. There is a big difference between a 2008 experience, and a 2001 cycle. Given that the U.S. economic cycle lacks the leverage excesses and the risky financial assets of 2008, a policy miss would more likely land the U.S. into shallow recession territory given that American households are in far better position to withstand pressure. In fact, since economic growth needs to recalibrate below potential to ease pressure on inflation, if it were to marginally overshoot and tread water in shallow negative territory for a short period, this should accelerate the recalibration. 

Q8. Are high inflation and rates going to knock out Canadian and U.S. consumers? 

• U.S. and Canadian households have benefited from a notable and broad-based improvement in their balance sheets during the pandemic. Low interest rates, loan payment deferrals, extensive government fiscal support, accumulated wealth and savings have all led to an improvement in financial risk indicators. Delinquency rates have declined across all financial products, and the number of households filing for insolvency also fell well-below its pre-pandemic average. 

• Despite this, consumer sentiment has weakened in both Canada and the U.S. in recent weeks as high inflation and rising interest rates erode households' optimism. There's no question that real consumer spending will slow over the coming quarters under the erosion in purchasing power. For example, according to the Bank of Canada estimates, 5% inflation will cost Canadians on average $2000 more per year compared to 2% inflation. 
• We estimate that higher interest rates will also increase annual debt servicing costs by about $2,000 per U.S. household and C$2,400 per Canadian household by 2023 Q1. Relative to disposable income, this increase should also be more manageable for U.S. families than their neighbors north of the border (Chart 6). Given these headwinds, credit performance indicators (i.e., delinquencies) have likely hit their trough and should begin to trend higher in the coming months. Fortunately, households are facing those challenges in a healthy labor market. Provided it stays that way, most borrowers should be able to remain current on their payments in the rising interest rate environment, as was the case during the 2017-2018 period.

Q9. Do rapid rate hikes risk burning down the house in Canada and the US? 

• The U.S. housing market has been hit with a rapid adjustment. The average 30-year fixed mortgage rate is currently about 5.30%, which is up 225 basis points from this time last year, and the highest since August 2009. In response, new mortgage applications have slowed (Chart 7). The typical mortgage payment for a median-priced single-family home is up roughly 50% from a year ago – far outstripping income growth. We estimate housing affordability has fallen to 2006 levels and is making itself evident with softer readings among several indicators (i.e., pending home sales, new home sales, mortgage purchase applications). There's also evidence that a growing (though still small) share of sellers are lowering their asking prices (as per Redfin data).
• The market has already begun to soften, and this will continue over the next several quarters (Chart 8). Our updated base-case forecast scenario reflects home sales falling by about 15% from the recent peak in the fourth quarter of last year. However, a tight supply environment, with resale home inventories still near the lowest levels on record, should help keep a floor on decelerating home price growth, with the latter expected to cool into low single-digit territory from its recent double-digit pace. 

• We also considered a separate scenario where the Fed's inflation fight requires rate increases to rise an additional 50 basis points relative our baseline. This more aggressive interest rate environment would take additional buyers out of the market through a further reduction in affordability. On the other hand, the potential for price expectations to weaken further might also encourage reluctant prospective sellers to finally take the plunge and list their homes. This would help to further ease the supply/demand imbalance and cut into home price growth slightly more. Investor activity also bears careful watching. Real estate investors snapped up one in seven homes sold across America last year – the most in at least 20 years. In markets with hot price growth, such as Atlanta, Charlotte, and Miami – all three in our East Coast footprint – investors accounted for a staggering one quarter of all homes sold in 2021. Investors are less likely than end users to hold on to property when market dynamics weaken. So, just as a strong investor presence in a market can accentuate price pressures on the way up, it can also amplify them on the way down. In short, regions with heavier investor presence could compel a stronger unwinding in prices if high rates or slower economic activity challenge the economics of holding on to these properties.

• In Canada, housing markets have begun to soften under the weight of higher rates. Home sales fell by 6% (m/m) in March, followed by a 13% decline in April (Chart 9). Meanwhile, home prices dropped by an average of 3.2% during the two months. Last month, home sales declined in month-on-month terms in places like Calgary and Vancouver but plunged nearly 30% in Toronto. The latter region seems to be the real outlier here, as supply/demand conditions have moved closer to favouring buyers, and average prices were down 6.4% during the month. In contrast, markets remained relatively tight elsewhere and price growth was stronger. It's no great surprise that the heat is coming off Toronto's market more than these other jurisdictions – this is the other side of the rapid runup that had Toronto challenging for the lead spot as the most expensive market in all of Canada in recent months.
• Our updated baseline forecast reflects Canadian home sales dropping by 25–35% on a Q4/Q4 basis this year as interest rates ratchet higher, before making up lost ground in 2023. This is a steeper decline than was expected in the U.S. and reflects a much worse affordability conditions in Canada. 
• Average home prices will naturally reflect this cooler demand backdrop, likely dropping by about 8% Q4/Q4 this year. This latter figure is boosted by a robust 8% (non-annualized) first quarter increase, with the average price in Canada expected to decline around 15% peak-to-trough. To put this perspective, given the massive price gains seen through the pandemic, that would leave the average home price still about 25% above its pre-pandemic level. This is not so much a market correction, as it is a recalibration. 
• Note that prices for more expensive units experienced a much steeper climb during the pandemic, and thus may have more room to drop. This could downwardly pressure average home prices, as they are influenced by transactions at either end of the price spectrum. We’ve already had some traces of this phenomenon. For example, March average home prices declined month-on-month, but benchmark prices (which are free of these compositional influences) increased. Meanwhile, in April, average home prices in Canada’s largest market (Toronto) dropped by 6.4% m/m, while benchmark prices cooled at a much lesser rate.
• Our baseline view is conditioned on the Bank of Canada (and Federal Reserve) ending the year with their respective policy rates at 2.5% -- the mid-point of neutral policy rate estimates for both central banks. However, it's plausible that the BoC and Fed could hike even more should inflation remain higher than expected. Under a scenario where policy rates rise to the upper end of neutral (i.e., 3%) by the end of the year, the Q4/Q4 drop in sales could be about 4 percentage points larger in 2022 and average home price growth could be reduced by an additional 2 ppts. However, there would be a more aggressive increase in sales and home prices next year under the higher rate scenario following a steeper decline in 2022. 

Q10. How is Canadian fiscal policy making BoC's job trickier? 

• Additional spending commitments were a key feature of the federal and provincial fiscal blueprints this budget season. Healthcare and education spending are both projected to grow solidly in coming years at the provincial level. Many provinces are also pledging tax relief for households, which are touted by governments to counter the impact on household incomes from inflation but don't necessarily remain constrained to lower income households who bear the brunt of the burden from high inflation. The story doesn't end there. Infrastructure commitments (especially at the provincial level) are also slated to add to growth moving forward. 
• Spending pledges will delay a return to surplus, and indeed, the combined deficit of the Big 4 provinces and federal government is expected to total 0.7% of GDP by FY 2024/25 (down from 2.9% in FY 2021/22). Meanwhile, robust infrastructure spending will keep the combined federal and Big 4 provinces net debt-to-GDP ratios from making any meaningful improvement over the medium term.  
• All told, we estimate that the combined provincial and federal measures will add about 0.5 percentage points to growth in 2022. This would mark a significant boost in any year, let alone one that's already pressing on capacity constraints with multi-decade highs in inflation. When policymakers don't row in the same direction, it can make the Bank of Canada's job harder in stabilizing the dynamics within the economy with its single, blunt tool: interest rates. Although Canada embeds more household debt risks than its neighbor to the south and is generally viewed as having a slightly lower neutral interest rate, it's possible the Bank of Canada will have to be more aggressive than its Federal Reserve counterpart to row harder against the stimulus wave. This is the inherent challenge of tightening cycles. Both the central bank and governments were quick to align on delivering stimulus when the economy soured under the pandemic, but there's typically more foot-dragging on the other side of a cycle when less supportive measures are required (see Dollars & Sense).