- The BoC became the first major central bank to “conditionally” pause its tightening cycle in January
- With Canada’s economy losing momentum we don’t see it restarting rate hikes
- Others aren’t ready to follow the BoC just yet and we’ve marked our ECB, BoE and RBA terminal rate forecasts higher
- A strong US payroll report has driven policy rate expectations higher but we continue to think fed funds will peak in March
- If labour market strength persists over the medium term (not our base case) terminal rate expectations will have to move higher
Pinning down terminal policy rates remains a challenge as central banks weigh slowing inflation and lagged effects of past tightening against mixed activity indicators and strong labour markets. The BoC became the first major central bank to hit pause on its tightening cycle after delivering a 25 bp hike in January, but others aren’t ready to move to the sidelines just yet. Equity and bond markets rallied last month as investors grew more confident that the Fed is nearing the end of its tightening cycle, but a surprisingly strong jobs report cast doubt on that view. Following a round of central bank meetings in early-February we’ve raised our terminal policy rate forecasts for the BoE (+50 bps), ECB (+25 bps) and RBA (+25 bps). We continue to assume the Fed’s next hike will be its last though payroll strength and Fed guidance leave risks skewed to the upside.
With inflation slowing but labour markets proving resilient, hopes for a soft landing are growing. After consistently trimming its global growth projections last year, the IMF revised its GDP forecasts higher in January, expecting a 2.9% gain this year that would be close to the global economy’s trend growth rate. Stronger-than-expected economic data and lower energy prices have us expecting a shallower recession in the UK, and a slowdown rather than outright contraction in the euro area. But we still anticipate mild recessions in Canada and the US in 2023 as recent indicators (outside jobs data) show both economies losing momentum late last year.
While labour markets remain too hot for central banks’ comfort, we think they’ll eventually follow the BoC’s lead and move to the sidelines after a year of aggressive tightening, waiting for an “accumulation of evidence” to support or oppose further hikes. Markets are generally priced for cuts later this year and in 2024, so if central banks are ultimately forced to resume tightening due to persistent inflation and excess demand (not our base case) the bond market would be in for a potentially painful adjustment.
Central bank bias
Current Policy Rate
+25 bps in Jan-23
+25 bps in Feb-23
+50 bps in Feb-23
+50 bps in Feb-23
+25 bps in Feb-23
BoC moves to the sidelines
The BoC delivered a widely-expected 25 bp hike in January, and while we assumed it would be the last of the cycle, the bank’s move to the sidelines was more explicit than we anticipated. Governing Council said that if the economic outlook evolves as expected—the BoC continues to see Canada’s economy stalling in the coming quarters—it will hold the overnight rate at its current level. Governor Macklem elaborated that it would take an “accumulation of evidence” in support of further hikes for the BoC to resume tightening.
We think that’s a wise approach given the lags with which monetary policy impacts the economy. The 425 bps of hikes delivered over the past year will be felt more acutely by households in 2023, in our view pushing average debt servicing costs to a record high and taking a bite out of consumer spending. Stepping back from the increased data dependence espoused in December reduces the risk that the BoC will over-tighten monetary policy by following lagging (and volatile) indicators like jobs numbers.
The BoC’s guidance should make March’s meeting a non-event by recent standards. April’s meeting and MPR is likely the earliest point at which the BoC would have enough evidence to resuming tightening, but we don’t see the data moving in that direction. Canada’s economy carried little momentum into 2023. StatCan’s preliminary estimate of Q4/22 GDP (+1.6% annualized) was below our assessment of the economy’s potential growth rate (slightly above 2%) for the first time in six quarters. StatCan suggested activity was “essentially unchanged” in December after increasing by just 0.1% in November, and our tracking of cardholder spending held steady in the early stages of 2023. While the labour market remained firm in late-2022, the BoC’s latest Business Outlook Survey pointed to slower future sales growth with firms paring back hiring and investment plans.
While there’s no clear evidence that a recession is currently underway, Canada’s economy appears to be running close to stall speed and we continue to think modest GDP declines are likely over the first half of 2023. That should keep the BoC on the sidelines, and is likely to increase the focus on potential rate cuts later this year. Macklem said it’s far too early for that discussion, and our forecast continues to assume the BoC will be on hold until early 2024.
Fed dials back but isn’t done yet
The Fed dialed back its tightening cycle with a 25 bp hike at the beginning of February. The policy statement called for ongoing rate increases, in line with December’s dot plot that pointed to an above-5% terminal rate. But Chair Powell offered less push-back than usual against market pricing for a lower peak rate and cuts later this year, attributing that to investors anticipating a faster improvement in inflation than the Fed projected in December. We continue to think the Fed’s end-of-2023 inflation forecasts (3.1% year-over-year for headline PCE and 3.5% for core) look too strong, particularly given recent trends (three-month annualized rates at 2.1% and 2.9%, respectively, in December).
While Powell didn’t guide policy rate expectations higher, a strong jobs report two days later did just that. The US economy reportedly added 517,000 jobs in January—a pace that stands head and shoulders above gains seen during the post-GFC recovery—and the unemployment rate ticked down to a fresh cycle (and half-century) low of 3.4%. Markets are now pricing in more than 50 bps of further rate hikes by mid-year and fewer rate cuts by the end of 2023.
We’re inclined to take the jobs report with a grain of salt, particularly as other non-labour market indicators paint a more mixed picture. The US economy expanded at a healthy 2.9% annualized rate in Q4/22 but private final domestic demand (i.e. consumer spending and private investment) increased at the slowest pace since the pandemic recovery began. Consumer spending declined in the final two months of 2022, led by a pullback in goods purchases, and industrial production also slowed. We continue to expect GDP will be flat in the first quarter of 2023. Clear signs that the economy is losing momentum and inflation is slowing should make the Fed’s March hike its last. That said, there is a risk that persistent labour market strength (even if not as robust as January’s payrolls) keeps the Fed hiking in May, in line with its December dot plot and current market pricing.
Will resilient labour markets keep central banks on the offensive?
While we’ve been emphasizing that the labour market is a lagging indicator—it’s not likely to point to a slowdown until we’re in one—the degree of resilience seen across many advanced economies is still surprising. As noted above, the US saw an unexpected (and somewhat puzzling) acceleration on job growth in January despite signs domestic demand is softening. Canada recorded average monthly job gains of 55,000 in Q4/22 (more than twice the pre-pandemic run rate) in the face of sub-trend GDP growth, and the jobless rate ticked down for second straight month in December. UK payroll employment growth remained robust late last year and the unemployment rate held near cycle lows even as the economy stalled. Both euro area and Australian jobless rates are now well below pre-pandemic levels.
And forward-looking labour market indicators aren’t particularly discouraging. Across most geographies, employment indices are the bright spot in otherwise lackluster PMI surveys, suggesting hiring demand remains solid. Job openings have come down from cycle highs but remain historically elevated. Fears that vacancies couldn’t decline without a significant increase in unemployment have thus far been unfounded.
Despite tight labour market conditions, wage growth appears to have peaked in some economies. Average hourly earnings in the US were up 4.4% year-over-year in January, down from a nearly 6% pace in early-2022. Two of Canada’s key wage measures are off their cycle highs but still running at 4-5% year-over-year. The key question for central banks is whether pay growth can continue to cool without a meaningful increase in unemployment that rebalances the job market. If current wage and productivity trends hold, it’s hard to see inflation returning sustainably to target.
Again, the labour market is a lagging indicator so we think central banks need to practice some patience in evaluating the pass through of monetary policy into economic activity, the labour market, wages and underlying inflation. We expect other central banks will soon follow the BoC’s lead and step to the sidelines to see how that process plays out. If, as we expect, economic activity and (eventually) job markets begin to soften, policy rates are likely to peak in the first half of this year and discussion will turn to when rate cuts might begin. But if labour market resilience persists well into 2023, central banks will be looking at restarting their tightening cycles rather than easing. We see that as an upside tail risk to the interest rate forecasts presented here.
Europe may dodge recession, UK to see shallower declines
The euro area defied expectations for a Q4/22 pullback, eking out a 0.1% non-annualized GDP gain to close out the year. A sizeable increase in often-volatile Irish GDP flattered the headline reading—growth would otherwise have been flat—and we think domestic demand was soft with country-level releases flagging a decline in consumer spending across the currency bloc’s largest economies. But survey data suggest growth prospects are improving, with the euro area composite PMI returning to expansionary territory in January for the first time in seven months. Our forecast now assumes the currency bloc will avoid an outright recession, though growth over the first half of 2023 is expected to be sluggish. While natural gas prices are at their lowest level since September 2021, they’re still two to three times pre-pandemic levels. Higher energy costs will continue to squeeze consumers and the industrial sector, leaving growth at a sub-trend pace in the near term.
It looks like the UK managed to avoid a second straight quarter of contraction with the economy expected to post a modest 0.1% GDP gain in Q4/22. Unlike the euro area, we don’t think the UK will be able to dodge a recession in 2023—the latest PMI data continue to point to modest declines in activity early this year. But we don’t think the slowdown will be as deep as previously feared, with the economy now expected to contract by 0.4% for the year as a whole rather than our previous -1.0% projection.
Looking for more hikes from the ECB, BoE and RBA
Following the latest round of central bank meetings, we’ve revised our terminal rate forecasts higher for the ECB, BoE and RBA. Hiking by an as-expected 50 bps in February, the ECB made clear that a similar increase should be expected in March (our previous forecast assumed 25 bps). It offered little explicit guidance beyond that, although President Lagarde said March’s hike was unlikely to be the last. We continue to expect a 25bp increase in May, with a larger move in March leaving the terminal deposit rate at 3.25% rather than our previously assumed 3%.
The BoE delivered a larger-than-expected 50 bp hike in February but hinted that it’s nearing the end of its tightening cycle. Governor Bailey’s comments and the MPC’s updated guidance effectively raised the bar for further rate hikes. We think the BoE’s next decision in March will be between a hold and a 25 bp hike, with our forecast now assuming the latter which would leave terminal Bank Rate at 4.25% (rather than the 3.75% previously assumed). But we think the BoE will move to the sidelines thereafter, like the BoC waiting for evidence to accumulate whether monetary policy needs to tighten further.
The RBA delivered another 25 bp hike, as expected, at its first policy meeting of 2023. But following a worrying set of inflation data—core inflation in particular was stronger than expected and well above the central bank’s forecast—the RBA’s messaging was more hawkish than late last year. Policymakers sounded particularly concerned about the potential consequences of persistently high inflation. With the statement pointing to further rate hikes “over the months ahead” we’ve added another 25 bp move to our forecast, with a terminal cash rate of 3.85% being reached in April.
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Josh Nye is a senior economist at RBC. His focus is on macroeconomic outlook and monetary policy in Canada and the United States. His comments on economic data and policy developments provide valuable insights to clients and colleagues, and are often featured in the media.
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