E-Sight Weekly June 6: Canadian GDP and Bank of Canada Policy Tightening

Last week had a very heavy economic calendar, with the Bank of Canada policy announcement and real GDP for the first quarter being the main events. The key takeaways are that while the Canadian economy had good momentum early this year, the outlook is for the central bank to engineer a significant slowing in Canadian economic growth in 2022 and the rebalancing of global monetary policy poses recession risks.

The Canadian economy delivered weaker-than-expected economic growth in the first quarter of 2022 coming in with a gain of 3.1% annualized, well short of market expectations for growth of above 5 percent. Nevertheless, the pace of real GDP growth was still solid and was in line with the Bank of Canada’s projections, implying that the performance won’t change the central banks stance on the outlook for growth and inflation.  

The details were much better than the headline, with final domestic demand growth by 4.8% annualized. Consumer spending was up 3.4 percent, with purchases of durable goods recording the strongest pace of growth. Residential investment was also strong with a gain of 18.1 percent. Business investment climbed 9.0 percent, with non-residential structures up 12.0 percent and machinery equipment climbing a more subdued 3.8 percent. The difference between domestic demand and the headline aggregate reflected a 9.4 percent drop in exports that outpaced a 2.8 percent decline in imports – but this weakness was partly a reversal of the excessive gains in both categories in the prior quarter. So, the final domestic demand growth was really a better indicator of the health of the economy.  

 All told, the report suggests that while the pace of economic expansion is moderating from the roughly 6 percent pace of growth recorded in the second half of last year, the gains in the first quarter were still close to twice the economy’s sustainable pace, rapidly reducing the slack in the economy and consistent with employment reports showing labour shortages from coast-to-coast. The multi-decade high rate of inflation is partly due to the price pressures created by global supply chain disruptions; but the rapid pace of domestic demand growth strongly argues for tighter monetary policy – and that is what the Bank of Canada delivered last week. 

The Bank of Canada hiked its benchmark short-term rate by a half percentage point – the second consecutive outsized interest rate increase. This lifted the overnight rate to 1.50 percent and the Bank committed to continuing its Quantitative Tightening policy that is reducing money supply growth. The monetary authority acknowledges that it fell behind the inflation curve and is playing catch up. On the prices front, it warned that, “inflation reached 6.8% for the month of April – well above the Bank’s forecast – and will likely move even higher in the near term before beginning to ease.” This seems likely given recent economic and financial developments. The Bank also delivered a hawkish view on the prospects for interest rates, “with the economy in excess demand, and inflation persisting well above target and expected to move higher in the near term, the Governing Council continues to judge that interest rates will need to rise further.” It could not be clearer about another increase next month.  

My expectation is that the Bank of Canada will hike another half percentage point on July 13, which will raise the overnight rate to the bottom end of its estimate of neutral policy, which it assesses as between 2.00 to 3.00 percent. At that point, I think the Bank’s messaging may shift to be more moderate. It could pause in its rate hiking cycle to see what the cumulative increase in interest rates will do or it could shift the pace of tightening down to the more normal 25 basis point rate hikes. The central bank knows that leverage is a huge problem in Canada, particularly on the household front. Every quarter point rate hike today will have a far bigger impact on the economy than in the past. By mid-July, short-term interest rates will have risen quickly by almost 2 percentage points. I think it would be prudent to assess the impact before doing more, particularly given that changes in monetary policy have an impact with a lag. However, the Governing Council of the Bank may feel that they cannot rest when inflation is high and still climbing. My bet is that the peak in the overnight rate will be close to 3.00 percent. The debate is really the timeline on getting there. The July fixed rate announcement date is also accompanied by the release of a Monetary Policy Report. This would provide the ideal opportunity to deliver one final large 50 basis point hike and then shift to signaling at least a slower pace of monetary tightening and explain why it is doing so.  

The Canadian economic growth is already slowing, and the tightening of monetary policy will ensure that the deceleration of economic growth will continue. There will continue to be speculation that high inflation and the interest rate shock could tip the economy into recession. This could happen, but it is not guaranteed. The economic slowdown will see significantly weaker residential real estate activity – and a contraction on this front is probably guaranteed. Consumer spending will moderate, but a contraction doesn’t have to be in the cards – particularly given the pent-up demand for consumer services created by the pandemic and the considerable savings that have been accumulated. Economic slowdowns are typically negative for business investment. However, the remarkable labour shortages and the growing wage pressures could trigger some much-needed capital substitution for labour. This would be a very welcome development, as it would be productivity enhancing.  

In my mind, the greatest recession risk comes from the rebalancing of US monetary policy and its impact on the American economy and world economy. The US economy is overheating more than Canada and last week’s economic releases were not comforting. US payrolls climbed 390k in May and the unemployment rate was unchanged at 3.6 percent. Unit labour costs soared 11.5 percent in the first quarter on top of 11.6 percent in the fourth quarter of last year. The ISM Manufacturing Index and ISM Services Index are signaling solid growth at a time that slack in the goods producing sector is virtually non-existent. The US Federal Reserve, just like the Bank of Canada, is rapidly reducing monetary stimulus. So, weaker economic times are ahead. A soft landing with slow economic growth and cooling inflation would be ideal, but the conduct of monetary policy is more art than science – meaning that it poses substantial economic and financial risks. If the US suffers a contraction, so too will Canada. Thus, one needs to watch US developments just as acutely, if not more so, as Canadian trends to assess the shape of the unfolding economic moderation.

Categories: Bank of Canada, Canadian Economic Outlook, E-Sight, Economics, Gross Domestic Product

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