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Addressing Issues Impacting the Economic and Financial Outlook

Date Published: February 21, 2024


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Inflation in advanced economies has made notable progress in recent months, enabling central banks to shift their warnings of potential interest rate hikes to dialogue around the timing for cuts. On the economic front, the U.S. remains a stark outperformer to peers. Despite geopolitical risks, and high borrowing costs, it continues to impress, buoyed by remarkable productivity. This is out-of-step with other countries where growth has cooled markedly. We explore these themes in our latest list of questions, while tackling other topics such as the ongoing risks from commercial real estate and renewed housing demand.

Q1. How are geopolitical risks impacting global growth, inflation risks and commodity prices?  

Chart 1 shows the price of moving a 40-foot container from China to Europe, China to the U.S. West coast and a global benchmark. The chart shows prices have risen for all routes since the fall of 2023. However, the total price gains are still much smaller than those observed during the pandemic and the total cost of shipment remains far below the peaks.

The escalation of Israel and Hamas tensions to surrounding regions continues to re-route ships away from the Suez Canal, and around the Cape of Good Hope to mitigate the risk of attacks. The diversion has pushed up container freight rates between China to Europe by roughly four-fold since October, while doubling shipping rates from China to the U.S. (Chart 1).

This means that supply chains are starting to elongate once again, and prices pressures are manifesting. However, the magnitude of the shipping shock is still a fraction of the pandemic era dislocations. There's also an offset coming from disinflationary forces at China's factories limiting producers' need to pass on further price increases.

This means that although the disinflationary forces among goods products may soon be on a short leash within CPI metrics, China's influence helps limit the extent to which a tailwind can build to lift global inflationary pressures.  

In addition, oil prices have largely shrugged off the potential for supply disruptions amid geopolitical turbulence. WTI has traded tightly between $70-75/barrel (bbl) for most of the last two months, suggesting little risk premium is built into prices. That said, should events translate to a physical removal of supply from the market, an oil price move to the upside is inevitable. In the coming months, prices should be primarily driven by fundamentals. Most notably for the outlook, key drivers include expectations for robust demand, the extent to which U.S. shale production slows, and OPEC+'s compliance to voluntary production cuts. Our inflation outlook incorporates an uptrend in oil prices back towards $80/bbl in the back half of the year. 

For industrial metals, the outlook is contingent on the demand picture – particularly China. New stimulus aimed at expanding investment in infrastructure and manufacturing could provide a lift to prices, but the upside is likely capped by the broader slowdown in industrial production and manufacturing. Despite weakening demand in 2023, inventories for key metals remain at historic lows, helping to keep a floor under prices. 

On a different front, tensions have cooled between China and the U.S. after the Biden/Xi summit last November. This has mitigated some of the geopolitical risks to the economy. Overall, the global economy is tracking slightly better than expected in our December outlook, with 2024 global GDP growth expected to register 2.8% (versus 2.6% in December). The largest risks are that the fiscal stimulus in China fails to produce the expected boost to demand or that the U.S. economy finally starts to groan under the weight of high interest rates

Q2. What is behind divergent inflation outcomes between the U.S., Canada and the euro area? 

Chart 2 shows the quarterly percent change in core goods and services prices for the U.S., Canada and euro area. The chart shows that core services prices in Canada and the U.S. continue to advance at over 5% annualized, whereas the gains in the euro are 2.6%. On goods, U.S. core goods prices are in outright deflation, whereas euro area goods prices continue to advance at 1.2%.

Through January, the annual change in the Consumer Price Index (CPI) was 3.1% in the U.S., 2.9% in Canada, and 2.8% in the euro area. However, these annual readings mask important nuances. Momentum in price gains has evaporated in Europe, while the same degree of deceleration has yet to be observed in North America.

In the euro area, both goods and services inflation has cooled substantially. The economy has completely stalled since the third quarter of 2022 (+0.04% GDP growth). Traditional economic dynamics have settled in to rebalance demand and supply, and to restore price stability. As a result, fourth quarter price growth has already cooled to roughly 2% (annualized) within both goods and services (Chart 2).  

The same cannot be said for the U.S. and Canada. Although Canadian economic growth has steadily evaporated, decades-long housing shortages are coming home to roost. Through January, CPI inflation excluding housing related costs (rent, mortgage interest costs, and replacement costs) has already returned to 1.8% year-on-year (y/y) and is at an even lower 0.6% (annualized) on a quarterly basis. Strip out the same housing factors from the classic core CPI (excluding food and energy) and it advanced only 1.5% (annualized) quarter ending in January.  The picture that emerges is of an economy with accumulating slack, not unlike Europe. But, differences in the methodology of the CPI metric within Canada creates greater distortion from shelter costs, which when combined with a severe supply shortage in the housing market, are going to prop up aggregate inflation for some time to come. It's for this reason that we detailed the related risks of leaving rates too high for too long in a recent report.

Lastly, we come to the U.S. where a resilient economy continues to defy gravity, raising the hopes of an immaculate disinflation. Services inflation has been less cooperative. It continues to chug along, running north of four percent on a quarterly basis. And, unlike Canada, this isn't a housing story. Stripping out the effects of rent and homeownership reveals a quarterly clip of price gains of 5.5% (annualized) through January. Outright deflation in core goods sets the U.S. apart as well, where January prices were down by 1.9% (annualized) on a rolling quarterly basis. Moreover, this print isn't out of the ordinary, in the decade before the pandemic (January 2010 to January 2020) the annual average price growth for core goods was zero. This means that if the downward pressure on goods prices begins to stall out in the face of strong domestic demand and an economy that remains in excess demand, the U.S. is at risk of a re-acceleration of inflation

Q3. When is the Fed likely to start cutting interest rates? 

With investors eagerly awaiting the start of central bank rate cuts, the Fed has been preaching patience on timing. The Fed's preferred core inflation measure – the core PCE deflator – has shown more progress than its CPI counterpart partly reflecting a larger weighting on (declining) goods prices. Under our baseline assumption that goods prices have some more room to fall, core PCE inflation should continue to grind lower to the mid-2% y/y range over the next few inflation reports. While this sounds great, this easing in inflation has come at a time when the U.S. economy has accelerated. The economy grew at a 4.9% quarter-on-quarter (q/q) annualized pace over the summer and barely 'slowed' to 3.3% q/q to close 2023. The first quarter GDP estimate is tracking again near 2%. This is not an economy that is anywhere near excess supply conditions.

Chart 3 shows the implied change in Fed policy rates from March to December 2024 in terms of basis points. It shows that both central banks are expected to cut rates, but that the Fed will lead.

Normally, a forward-looking Fed would foresee a higher risk of demand-fuelled inflation, which would prevent them from easing. But Fed Chair Powell has recently communicated that a strong economy may not stand in their way if inflation can continue its downward journey. For this to happen, it would suggest supply side adjustments remain the main driving force of recent disinflationary dynamics and/or America's outperformance in productivity persists to offer a well-timed counterinfluence to demand-push pressures. One thing is for sure, more time is needed to observe dynamics, particularly after a disappointing CPI report for January that reminded investors that this last leg down on inflation will not be a straight line. The Federal Reserve needs to be convinced beyond a shadow of a doubt. The beginning of a rate cut cycle is still in the cards, but the timing will remain hotly debated. We deem the likely opportunity to be around mid-year.  

Overall, the Fed has been communicating that the policy rate is at it's peak, but don't expect a rate cut in the immediate future, ruling out a decision at the March meeting. After that point, it's an open field, as central banks are hesitant to telegraph too far in advance given the uncertainty of the data. Investors are settling in at around mid-year, which is still reasonable (Chart 3). However, we deem the bigger discussion to be had is not on the precise start date of a cut-cycle but on the speed of descent. On this, we judge 100 basis points by year-end is within the realm of possibility for the U.S. if inflation remains cooperative. If so, the Fed can achieve an easing of its policy stance while maintaining rates in restrictive territory to mitigate risks of a flare up in inflation.

Q4. Will a resurgence in housing demand run afoul to central bank rate cut intentions?  

The move lower in borrowing costs in the fourth quarter of last year drove a stronger than expected uptick in housing activity.The U.S. housing market saw pending home sales shoot higher by 8.3% in December – a move that signalled a pickup in housing demand to cap off the year. Although the moderate backup in long-term yields and mortgage rates in recent weeks has likely leaned against this budding strength, the risks are elevated that once the Fed starts to cut interest rates, housing activity could swiftly rebound.  

Chart 4 shows year-on-year growth for three series: the PCE Housing Index and the New Rent Index (with a three-quarter lead) on the left-hand side, along with the CoreLogic Home Price Index (with a six-quarter lead) on the right-hand side. The chart shows that based on the lead provided by the New Rent Index and CoreLogic HPI, PCE housing inflation should continue to trend lower over the next few months.

Even so, there's an air pocket for the Fed to navigate. Current U.S. shelter dynamics have reflected some relief from a softer rental market, which feeds through with a notable lag to inflation metrics by several quarters (Chart 4). Mapping this inflation component against home prices (which over the long-run tends to influence rents) yields a similar result. This suggests that shelter inflation growth has further room to cool before it begins to reverse course again through the tail-end of this year. This "wave effect" in how lags feed through offers the Fed a window to cut interest rates even in the event of a hot spring housing season. However, it's also a key argument on the "go slow" approach to easing monetary policy. FOMC members expect only 75 basis points in cuts this year, which is half of what markets were expecting a month ago. Like the Bank of Canada, the intricacies of shelter inflation will present a communication challenge for the Fed too.

Q5. How is U.S. fiscal policy expected to impact growth?   

Federal fiscal policies have been a key ingredient in the U.S.'s outperformance over the past few years. These policies included trillions of dollars in pandemic-related economic stimulus in 2020 and 2021, in addition to the more recent landmark legislations of the Infrastructure Investment and Jobs Act (IIJA), the CHIPS & Science Act, and the Inflation Reduction Act (IRA). All three of these bills have resulted in massive amounts of public and private investment despite a rapid rise in interest rates. While the initial stimulus impulse from these packages has partially receded, each is expected to continue to provide support to economic growth as work continues on the associated projects.

Chart 5 shows the percentage point contribution to annual real GDP growth from government consumption & investment, broken down between federal and state & local. Government spending was a drag on economic growth between 2011-2014, before supporting growth between 2015-2020 with the 2019-2020 period seeing notable strength. Government spending's share of GDP growth dipped into marginally negative territory in 2021-2022, before rebounding strongly in 2023 to levels consistent with the 2019-2020 period. Moving forward, government spending's contribution to GDP growth is expected to gradually recede in 2024-2025.

However, new federal spending measures are expected to be limited in 2024 as Congress targets discretionary spending caps in the yet-to-be passed annual budget. A provisional agreement between Congressional leaders would see defense spending grow by roughly 3%, while non-defense spending would be flat, consistent with the limits agreed with in the Fiscal Responsibility Act (FRA) of 2022. However, the federal government is currently funded under a continuing resolution that runs through early March, the third such one passed since the fiscal year began in October. Failure to pass the 2024 budget by April 30th will trigger automatic spending cuts legislated by the FRA, including a 1% cut to defense and non-defense discretionary spending. While this represents a modest risk to the economic outlook, federal expenditures are expected to see slower growth moving forward regardless, although the FRA cuts would accelerate the decline (Chart 5).

In addition, state and local government (S&L) spending growth has also been elevated. State budgets have been bolstered by the $350 billion State and Local Fiscal Recovery Funds set out in the 2021 American Rescue Plan Act. These funds must be allocated by the end of this year and spent by the end of 2026. S&L spending has also been boosted by the projects related to the same federal bills mentioned above (IIJA, CHIPS, IRA). The competition to attract the related private sector investments has further pushed up S&L spending, creating another tailwind that will take time to recede.

Q6. What is going to slow the U.S. economic juggernaut in 2024?  

The U.S. economy roared through the second half of last year, causing analysts, including ourselves, to have an embarrassing degree of forecast miss. Growth in the second half averaged 4% and the October-December period marked the sixth consecutive quarter that economic growth either met or exceeded its long-run potential growth rate, despite the federal funds rate remaining well into restrictive territory.

Consumer spending has been a key catalyst, even as excess savings have become increasingly depleted, and millions of borrowers have resumed regular student loan repayments. The ongoing strength can be traced back to the robust labor market and ongoing gains in real household income. Falling gasoline prices and easing food inflation have also provided a tailwind, by freeing up some additional cash which has ultimately filtered into stronger discretionary spending.  

Chart 6 shows the CBO's projections of the expected infrastructure investment outlays over the coming decade by state and local governments. In 2023, outlays were just $21 billion which was a sharp uptick from 2022's $3 billion. Outlays are expected to peak in 2026/2027 at around $68 billion, before slowing to $8 billion by 2033. Data is sourced from the CBO as of February 2024.

As outlined in question 5, state & local government (S&L) has also been punching above its weight – adding 0.4 percentage points to growth in 2023 (see Chart 5). This spending push could very well extend over the coming years, particularly given that COVID relief funds will need to be designated for specific uses by the end of fiscal 2024 (and deployed by the end of FY2026). In addition, authorized funds through the Infrastructure Investment & Jobs Act (IIJA) have only recently translated to shovels in the ground (Chart 6).

All of this leaves the impression that the U.S. economy is immune to higher interest rates, but it's more likely that the lags are just longer in this post-pandemic cycle. From the consumer standpoint, spending growth is now outpacing income by a wide margin, leaving households increasingly reliant on consumer credit – as evidenced by rising credit card utilization rates. With excess savings for low-to-middle income households largely exhausted, consumer spending is running on fewer growth-impulses. Headwinds are also persisting from tight lending standards, elevated interest rates, and there's also the potential for political uncertainty related to the election to weigh on near-term business investment. But even with these headwinds, U.S. growth is still expected to expand by 2.53 this year – nearly matching 2023's rate of expansion. This annual average growth is flattered by a strong hand off from 2023, with growth expected to slow to 1.5% by the end of the year (on a Q4/Q4 basis). But even this pace will far outstrip its peers, which means the global theme of American exceptionalism will remain intact for at least another year.

Q7. Where do the risks stand for U.S. commercial real estate?  

Higher interest rates have not been kind to Commercial Real Estate (CRE), with deal activity drying up and property values, especially those for the office sector, trending lower. At roughly $540 billion per year in 2024 and 2025, the volume of CRE loan maturities is expected to remain elevated, but relatively steady compared to last year.  But the ongoing deterioration in overall market fundamentals points to a potentially bumpier road ahead. CRE remains a long tail risk within the forecast. It will continue to take time to play out with the likelihood of rolling flare-ups within certain financial institutions. But it's not believed to have a deep reach into undermining financial stability that would upset the broader economy.

Chart 7 shows vacancy rates for four key commercial real estate (CRE) sectors with data stretching back to year 2000. The chart shows that the vacancy rate for the multifamily and industrial sectors has been on the rise for several quarters, while the vacancy rate for the office sector sits at an all-time high. Retail is the only sector whose vacancy rate has continued to trend lower over the last few quarters.

So far, the delinquency rate of all CRE loans issued by banks in the U.S. stands at 1.1%, much lower compared to prior periods of stress such as the GFC, but it still exhibits a noticeable upswing recently. CRE weakness continues to be centered around the office market, where the vacancy rate has risen to an all-time high. CMBS loan data shows that the delinquency rate of loans backed by office properties has risen sharply over the past year, to 6.3% in January from 1.9% a year ago. The other main CRE sectors are generally better positioned to withstand the pressure of maturing loans in a higher interest rate environment, but rising vacancies in the industrial and multifamily space could bring about more signs of stress (Chart 7). On the plus side, prospects for a further move downward in longer-term yields, and a relatively resilient U.S. economy, should help limit the fallout.  

Roughly half of the loans slated to mature over the next few years have been originated by the banking sector. As has been well publicized, some smaller regional banks are more exposed to CRE debt, and potential losses related to these loans can cause financial difficulty for these institutions. But, their exposure to the weakest corner of CRE – the office market – is more limited. In addition, once factoring in nonbank players in the CRE lending space (i.e., Life insurance companies, CMBS etc.) the overall exposure and perceived risks tied to the smaller banks is much lower. Meanwhile, larger banks are better capitalized to handle the stress. These are all elements that should serve to limit risks, or the systematic nature of that risk within the broad economy. Speaking on this issue recently, Fed Chair Powell agreed, noting the potential for some smaller banks to 'close or be merged out', but stated that that CRE risks present a 'manageable' problem for larger banks, and that there isn’t much risk of a repeat of 2008.


Contributing Authors

  • Beata Caranci, Chief Economist | 416-982-8067

  • Derek Burleton, Deputy Chief Economist | 416-982-2514

  • James Orlando, CFA, Director | 416- 413-3180

  • Leslie Preston, Managing Director | 416-983-7053

  • Thomas Feltmate, Director | 416- 944-5730

  • Andrew Hencic, Senior Economist | 416-944-5307