2023 has started off on a better-than-expected footing, resulting in an upgraded outlook over the next two years. However, that doesn’t mean the braking force from higher interest rates is finished, the peak impacts are yet to be felt and economic momentum is still expected to be sub-par this year. Higher borrowing costs have already sent the housing sector into reverse, and the production side of the economy has started to flatline.
Now, the failure of two U.S. regional banks has brought a new risk on the block. Ahead of next week’s FOMC meeting, markets had initially leaned towards a 50-basis point interest rate hike, but that is now off the table, and we agree. Although the Federal Reserve is not one to be responsive to typical market gyrations, this is not a typical event. Investors are still weighing the possibility that others could be waiting in the wings, which ultimately reflects a confidence crisis. The response to shore up that confidence was swift by the Federal Reserve, Treasury and FDIC. Measures included a guarantee on deposits of all amounts and a new bank lending facility to support liquidity tensions. But time will be needed to settle nerves and ensure there will not be other unforeseen contagion effects in other segments of the market.
This week’s events ring familiar to the quantitative tightening cycle in 2019, even though the two periods are unrelated. The portion that is “familiar” is that market limits appear in unexpected places when the central bank presses into unprecedented territory. And this ultimately changes the game plan. Back then, the draining of assets from the Fed’s balance sheet was going perfectly smoothly, until it wasn’t. During September 2019, the Federal Reserve was caught off guard with a sudden need to halt quantitative tightening when strain showed up in money markets under a perceived benign influence. A common seasonal pattern that reflected an overlap of a corporate tax date and an increase in net Treasury issuance subsequently caused sharp upward pressure on money markets – far greater than could be explained by these usual seasonal influences. What should have been a modest strain in money markets faced an amplifier against a backdrop of declining reserves under the Fed’s balance sheet normalization process. A threshold was discovered on what the market could tolerate or absorb. Today’s events carry a similar theme.
The economy can certainly support higher interest rates – as evidenced by the solid job market and stubborn inflation – but the Fed’s unprecedented rapid rate hike cycle has exposed a vulnerability within smaller regional banks and their deposit holdings, as investors seek out higher yielding investments. Until market confidence is fully restored and assured on a longer-term basis that there are no more SVB’s lurking, the Fed will prioritize financial stability over the near-term economic data. Due to the timing of publishing our forecast, we have embedded a 25bps hike at the March 22nd meeting under the view that financial markets will settle down between now and then. However, there is no urgency on that rate hike if confidence has not been restored. In fact, if market confidence is undermined over a prolonged period, it will feed into the real economy and negatively impact hiring, investment and spending intentions. This would put an earlier end to the Fed rate hike cycle than they had anticipated.
Globally, there’s greater confidence that the collection of last year’s risks have passed a peak uncertainty period, but there is ample reason for caution to leave a mark on the outlook. Peace seems far away in Russia’s war in Ukraine, and the pandemic continues to cast a long shadow on the economic data. Despite a normalization in global supply chains, inventory swings remain outsized and shifting seasonal patterns are contributing to data volatility. Calling a turning point in the data will be difficult and raises the risk that central banks misread the tea leaves.
Global outlook improves as peak uncertainty passes
Two key reasons that peak uncertainty has faded from the global outlook are due to an improvement in energy market conditions in Europe and the end of China’s zero-COVID strategy. We still expect global growth to slow from 3.3% in 2022 to 2.8% in 2023, but this is an improvement from our December forecast.
Some of the credit goes to Mother Nature. Unseasonably warm weather in Europe reduced demand for heating and helped the region avoid a worst-case scenario during its energy crisis. While the peak tension period has passed, energy supplies remain a risk. The continent faces the prospect of higher electricity costs in the summer months due to the increased risk of droughts and with nuclear generating capacity offline for maintenance in France. And, Europe has a huge inflation problem. Falling energy costs have not yet filtered through to core inflation, which is running higher than in North America over the past three months. The European Central Bank is in an earlier phase of its rate hike cycle and further tightening is still necessary to rein in inflation.
China’s economic recovery is shaping up to be as impressive as it is quick. So far in 2023, PMI indicators suggest a post-lockdown recovery in demand should provide a healthy boost in the first quarter. However, this lift will be temporary, as the country still contends with a slowdown in the property market. China is deleveraging, which is typically a prolonged process, raising the risk that growth disappoints after the initial spurt. Chinese authorities have set a modest growth target of 5% for 2023, which we suspect they could overshoot, but the opposing forces within the economy mean that any near-term burst of activity should moderate in the latter half of the year.
Global resilience presents a risk to the commodity price outlook. If China outperforms our expectations, there is upside risk to our oil price view and to headline inflation.
Good news is bad news for the U.S. economy
Turning to the U.S., the economy ended 2022 on a solid note with fourth quarter GDP growth advancing 2.7% (annualized). However, that figure was goosed up by a sizeable boost in inventories that masked flat domestic demand. Nothing seems to move in a straight line these days and the first quarter reflects a tug-of-war between sturdy consumer spending and backtracking residential investment. The current quarter is revealing ongoing consumer resiliency, and some upside starting to appear on the residential side of the economy.
All this adds up to another upgrade to economic growth in 2023 and 2024, albeit to a still sub-trend pace of 1.3% and 1.0%, respectively. But, in the current overheated economy, good news is bad news, as it comes alongside an upgrade to our inflation forecast (Chart 1). Core inflationary pressures will not go gently into that good night. January introduced a double hit to market optimism on inflation. The data for the month of January halted a nascent downtrend that had emerged in the three-month annualized measure for core services – a Fed favorite measure of late – and that trend only worsened in February. This was made worse by revisions to the past data that revealed far more persistence. As a result, inflation forecasts were marked up. The Fed’s terminal rate would likewise have been lifted closer to the 6% mark if not for caution injected due to the recent failure of two regional banks.
Regardless of recent financial events, the road to lower inflation still runs through the labor market. So long as job vacancies remain elevated, wage gains will continue to run above a level consistent with 2% inflation. There have been some early signs that job openings are coming down in key cyclical sectors like construction, but the data lacks breadth across industries. Hiring has a long way to slow before the Federal Reserve would have comfort that the labor market is moving back into balance. All in, this adds conviction to our view that a slower, more prolonged period of sub-trend economic growth is a more likely outcome than a short recession followed by a return to near-trend growth in the following year. However, no matter the economic trajectory, a rise in the unemployment rate is a consistent theme across forecasters. We estimate the unemployment rate needs to rise by at least 1.2%-pts to normalize job vacancies and restore balance in the labor market.
Canada’s economy in wait and see mode
In contrast to the U.S., Canada’s economy ended 2022 on a soft note, with overall activity stagnant in the fourth quarter. However, here too inventories were the catalyst. Canada experienced a sizeable drawdown in inventories that shaved over 5 percentage points from GDP growth. Even so, domestic demand was still soft at only 1% due to a widening wedge between a resilient consumer and contracting investment among businesses and the residential sector. That wedge is not just a manifestation of a strong job market feeding into the consumer cycle, but also a strong influx of government transfers that boosted after-tax household incomes well beyond inflation. This runs the risk of frustrating the Bank of Canada’s attempt to cool the domestic impulse to inflation.
Like the U.S., the labour market has been incredibly strong. However, several pieces are not adding up, and we expect job gains to slow dramatically in the coming months, as employers must reconcile with incredibly weak productivity and contracting profits. The impact of higher borrowing costs should also build on consumer patterns as the year rolls forward and more households face mortgage renewals at higher interest rates. Some households may be able to skirt the immediate impact on budgets by adjusting to longer amortization periods, but not all. And even for those in the first category, the longer period required on servicing debt can lead to a more cautious approach to discretionary spending.
The rise in mortgage rates has an immediate impact on housing demand, and after a year of cooling, the data are beginning to improve. However, important risks remain on the horizon. As events in the U.S. banking sector over the past few days show, we are not done with volatility on the interest rate front. We continue to expect the Bank of Canada to remain on pause with interest rates. But uncertainties remain on the policy front. OSFI has signaled new rules may come in place for the management of household leverage risks and there’s always the risk that the BoC is forced to resume raising rates.
Canada’s inflation has cooled a bit faster than expected (Chart 1), but this is partly because of a helping hand from government policy via dramatically lower daycare costs and energy rebates in some provinces. In other words, these are not due to cyclical forces tied to the job market, which can reignite inflation. For now, the trend in price pressures have been encouraging within several segments, from household furniture and appliances to shelter costs and airline fares. However, getting price pressures to trend down from lofty levels is not the same as building confidence that it will get all the way back to 2%. So, while the BoC can remain in wait and see mode, the burden of proof remains very much on the data to deliver to expectations.
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