Flagging growth won't derail central bank rate hikes

Highlights

Central banks are hiking interest rates aggressively. Global price pressures appear to be easing. Key commodity prices are lower and ocean shipping costs and times have declined.

But inflation has been too high for too long—heightening the risk that longer-run inflation expectations will come unhinged from central bank targets. That would upend decades of successful inflation targeting monetary policy. It would also require significantly higher interest rates (and a much larger slowdown in economic activity) to counteract.

That hasn’t happened yet. Some measures of longer-run inflation expectations have moved lower over the last month and market implied longer-run inflation rates have declined. But from a central bank’s perspective, the risks of not doing enough to cool overheating demand probably outweigh the risks of doing too much.

Against that backdrop, the Bank of Canada has continued to ‘front-load’ interest rate hikes. In July, it unveiled the first full percentage point increase in the overnight rate since 1998. Later that month, the U.S. Fed followed with a second-consecutive 75 basis point hike. And both banks are expected to quickly push interest rates into moderately ‘restrictive’ territory. We look for the BoC to hike the overnight rate to 3.5% this year (up another percentage point from current levels). In the U.S., we also expect the Fed to hike by another 125 basis points, hitting the 3.50% to 3.75% range by end of year.

Rising recession odds unlikely to deter central banks

In our view, those interest rate increases will ultimately tip the U.S. and Canadian economies into moderate recessions next year. Overseas, interest rates are also on the rise. In the Euro Area, we expect a downturn to begin later this year. Growth is also softening in the United Kingdom. The drop in demand that accompanies these developments is expected to help lower inflation. But that doesn’t mean central banks are done hiking rates. While a ‘mild’ recession is likely in the cards, forceful action from central banks now is meant to avert a much more damaging recession in which wage and price inflation spiral out of control.

Global inflation pressures may have hit their peak

In the U.S., the recovery in household spending on services is still going strong. But purchases of merchandise in June declined 3% compared to a year ago. Meantime, supply chain pressures have eased, ocean shipping times and costs have declined (bringing more goods into ports). As a result, a glut of inventory has emerged in stores, raising the prospect of outright price declines for some products.

As this plays out, key commodity prices are falling. And the 25% drop in oil prices from early June will help lower headline inflation rates over the summer.

Central banks will be cautious about reversing interest rate increases too quickly. But as long as the economy and inflation slow as we expect, the Fed and BoC will both be in a position to begin easing interest rates in the second half of 2023. Indeed, the expectation that central banks won’t be able to maintain ‘peak’ short-run policy rates for too long has already pushed longer-term bond yields lower. Ten-year government bond yields fell by 60 basis points in Canada over the last month, and 30 basis points in the U.S. That has caused the spread between longer-run (10-year) and shorter-run (2-year) government borrowing costs (a closely watched recession indicator) to invert sharply in both regions.

U.S. GDP declines don’t count as a ‘recession’ (yet) but cracks are forming in labour markets

The U.S. posted two consecutive quarterly GDP declines in the first half of this year. That doesn’t yet count as a recession because labour markets have continued to improve. The unemployment rate fell to pre-pandemic levels (matching a 5-decade low) in July and payroll employment surged by 528,000—adding to the 2.8 million increase in jobs over the first half of the year. Still, cracks are starting to appear and we continue to expect a more broadly based softening in the year ahead. Weekly jobless claims have been increasing steadily since mid-March and are outpacing the rate of increase typically seen ahead of historical recessions. Labour markets have been exceptionally tight, and for now, excess hiring demand has been enough to offset those job losses. Job openings are still running more than 50% above pre-pandemic levels, but the pace has been waning. We look for job markets to soften going forward as labour demand continues to ease and layoffs rise.

Bank of Canada to continue to hike despite softer housing markets

Higher commodity prices and the recovery in Canada’s travel and hospitality industry have supported near-term economic growth. We’re tracking a 4.5% (annualized) increase in GDP in Q2. And at 4.9%, the unemployment rate in June and July was at record lows (dating at least back to 1976). Still, shortages of labour are capping production growth and higher interest rates and inflation are cutting into household purchasing power. Housing markets have pulled back dramatically with home resales down 27% between March and June. National benchmark home prices have started to decline (-3% April through June) and more declines are expected as central banks continue to raise interest rates. An excess of demand in labour markets is keeping unemployment very low for now—job openings are running more than 60% above pre-pandemic levels—and pushing wages higher. But we continue to expect economic growth to slow substantially over the second half of 2022.

Euro area to reach terminal rate sooner on an accelerated hiking path

Euro area PMIs continued to contract in July. Services sector PMIs also exhibited broad-based slowing as the amount of new orders and backlogged work fell. Russia’s invasion of Ukraine continued to stoke concerns surrounding energy and supply chains, and persistently elevated inflation hampered business expectations and weighed on buying activity. Retail trade data signals a notable slowdown in purchases as well, both in the Euro area and the European Union. This suggests recession risk may be higher than previously anticipated. But the ECB has joined other global central banks in “front-loading” its hiking path, ratcheting the deposit rate up 50 basis points in July. We changed our interest rate outlook to reflect an accelerated hiking path, while leaving the terminal rate at a neutral level (1.5%) by Q1 2023. The ECB is now expected to hike the deposit rate by an additional 25 basis points in Q3, reaching 1.5% by the end of this year. 

U.K. activity slowing with more upside risk to CPI growth

U.K. GDP grew 0.5% in May, notably stronger than the 0.2% increase we’d anticipated. May gains were driven by strength in manufacturing, construction, and services sector output. At the beginning of Q3, however, manufacturing activity appears to be slowing with both output and new orders on the downswing. Falling commodity prices (including global energy prices) lowered producers’ capital costs, but businesses continue to face salary pressures as soaring inflation persists. The U.K. labour market remains extremely tight with elevated job vacancies and 3.8% unemployment. The services sector continues to outperform the goods sector, with strength mostly concentrated in health and social work. Activity in accommodation and food services and retail is waning in the face of soaring services inflation (up 5.2% in June). We continue to expect record price growth to worsen once semi-annual price increases take place in October—presenting more upside risk to CPI growth toward the end of this year. The BoE continues to front-load its hiking cycle, with an outsized 50 basis point hike in August to 1.75% expected to support this goal. We anticipate, however, that the remaining interest rate decisions will result in 25 basis point moves until the bank reaches a terminal rate of 2.75 by mid-2023.

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