E-Sight July 11: Waiting on Macklem

All eyes are on this Wednesday’s Bank of Canada’s interest rate announcement. Financial markets have priced in a 75 basis point increase in the benchmark overnight rate, matching the last move by the US Federal Reserve as both central banks scramble to play catch-up to inflation that is running roughly four times the desired pace. The rate announcement will be accompanied by the release of the Bank of Canada’s Monetary Policy Report (MPR), which will include updated economic forecasts. Markets will wait with bated breath for the press conference with Governor Tiff Macklem for any signals about the path of monetary policy going forward.  

Last week’s economic data may have been a bit mixed, but key elements will support the aggressive tightening of monetary policy. Although a surprising 43 thousand jobs were lost in June, the unemployment rate fell 0.2 percentage points to a new record low of 4.9 per cent and wage growth accelerated to 5.2 per cent year-over-year – up from 3.9 per cent in May. The rising wage pressures will be of particular concern to the monetary authority because it can turn into an inflationary spiral if employers feel they must pass the higher labour costs along to consumers. 

Recent Bank of Canada surveys also flashed bright warning lights. The Business Outlook Survey reported that firms expected to raise wages 5.8 per cent over the next twelve month. Both the Business Outlook Survey and the Survey of Consumer Expectations showed 2-year ahead inflation expectations climbing. This is a problem. If businesses and consumers behave as if inflation will be higher than the Bank’s 1-to-3 per cent target band, and prices and contracts are set on this basis, then it will be self-fulfilling, and inflation will be above target. 

So, the Bank of Canada is absolutely right to be raising interest rates and it will depress activity in interest-rate sensitive sectors of the Canadian economy. Indeed, Canadian residential real estate markets are already pulling backing fast. The question is whether the tightening of monetary policy will trigger a recession? And, the jury is still out. High commodity prices, considerable household savings, tight labour markets and labour scarcity are just a few key sources of resilience in the economy at the moment. However, the rapidly rising cost of living and the interest rate shock could quickly turn the tide. My preference would be for the Bank of Canada to get the overnight towards neutral (around 3.00%) and then pause to see the impact on the economy. I still think a lot of inflation is coming from the supply side, but the Bank does have to reign in inflation expectations. I just hope it doesn’t need a recession to accomplish that.

While most economic forecasters have stuck with a slowdown base case forecast, RBC garnered lots of headlines last week as it became the first Canadian chartered bank to adopt a formal recession call, predicting a 0.5 per cent annualized contraction in the second and third quarters of 2023 that still leave the economy growing by 0.8 per cent in 2023. In my mind, I am not even sure this is really a recession. That means the unannualized changes in the second and third quarter are a mere -0.1 per cent that could disappear with data revisions. I believe that if there is a recession, the downturn would be far deeper. Not as bad as the financial crisis of 2008/09 or the pandemic, but I could see the economy contracting by 2-3 per cent in 2023 – which would be more in keeping with a normal business cycle. I hope RBC is right and I am wrong. 

If the business cycle does turn, keep in mind that the contraction does tend to be a two to three quarter period, after which the delivery of fiscal and monetary stimulus helps to trigger a recovery and then subsequent expansion. Recessions shouldn’t be feared. They should be understood and managed.

Categories: Bank of Canada, Canadian Economic Outlook, Canadian Inflation, E-Sight, Economics, Interest Rate

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