Past the peak

Highlights

Inflation is slowly starting to retreat from multi-decade highs, helped by falling energy prices and in some cases government relief programs. Oil prices are now at year-to-date lows (WTI is more than 40% below its post-invasion peak) as global growth concerns mount and Russian supply holds up in the face of fresh sanctions. Fading energy base effects will see headline inflation rates continue to ease in 2023. Core inflation is proving stickier and wage growth has picked up as labour markets remain resilient, suggesting it’s too early for central banks to declare victory in their campaigns to quash inflation. But with economic activity slowing and more attention being paid to the lagged impact of rate hikes, peak policy rates are in sight. We think the BoC will be the first to move to the sidelines in January, having opened the door to a pause at last week’s meeting. The Fed, BoE and ECB are expected to hike by 50 bps this week but should signal in one way or another that their tightening cycles are nearing an end. Along with the RBA we don’t see these central banks raising rates beyond the first quarter of 2023.

As they approach terminal policy rates, central banks are likely to follow the Fed’s cue and emphasize the need to keep monetary policy restrictive for a period of time. With above-target inflation delaying any response to an economic slowdown, we think most central banks will be on hold throughout next year. The Fed, having taken its tightening cycle the furthest, will likely be the first to cut rates in late-2023. Longer-term government bonds have already started to rally and we think the short-end will do so next year as market focus shifts from remaining rate hikes to eventual cuts. That will reverse some of the curve flattening seen in recent months—yield curves are now deeply inverted in the US and Canada, and more recently in the UK and Germany, as at least a mild recession now looks unavoidable.

BoC signals a pause after one more oversized hike

After a dovish surprise in October, the BoC landed on the hawkish side of consensus in December with a second consecutive 50 bp hike. That lifted the overnight rate to 4.25%—a cumulative 400 bp increase since March. While the rate decision itself was hawkish, the accompanying policy statement leaned dovish with the BoC shifting to an even softer tightening bias than we envisioned: “Governing Council will be considering whether the policy interest rate needs to rise further.” That clearly opens the door to a pause as soon as the next meeting in January, and in our view frames that decision as between 0 and 25 bps.

Near-term focus will be on whether the BoC is done its tightening cycle (more on that below) but we think the bigger question for markets is how long it holds the overnight rate at its terminal level. While the Fed has emphasized it will need to keep monetary policy “at a restrictive level for some time,” the BoC has provided less medium-term guidance. While we expect Canada’s economy will slip into recession in the first half of next year, a starting point of excess demand and above-target inflation will keep the BoC from reacting to that slowdown as quickly as it has in past cycles. We think monetary policy will be on hold throughout 2023 though yields are likely to decline over the course of the year as eventual rate cuts come into view.

Further evidence that inflation is turning a corner

Canadian inflation has been fairly steady in recent months with headline CPI stuck around 7% and core inflation generally closer to 5% year-over-year. But monthly inflation readings have started to slow with core measures running below 4% on an annualized basis. In its December policy statement the BoC pointed to that as “an early indicator that price pressures may be losing momentum.” Diffusion measures also suggest the breadth of inflation has started to narrow, a sign that widespread inflationary pressure isn’t becoming entrenched. With economic activity slowing we think those trends will continue in the coming months, supporting a pause by the BoC in January. But fully returning inflation to target will be a slow process—we don’t see core inflation getting back to the BoC’s 1-3% target range until 2024. Headline inflation will come down faster as base effects from rising food and energy prices fade—we think all items CPI will be close to 2% by the end of next year.

Canada’s labour market holding up…

We think recent resilience in Canada’s labour market was one of the reasons the BoC opted for another oversized hike in December. Canada’s economy added an on-consensus 10,000 jobs in November, avoiding giving back any of the unexpectedly strong 108,000 gain seen in the prior month. It remains the case that trend employment growth has slowed—an average of just 4,000 positions added in the past six months—but sluggish labour force growth has kept the unemployment rate close to 5%. Strong demand for labour has pushed wages higher, and whether the LFS (wage growth north of 5%) or SEPH data (around 4%) are closer to reality, the recent pace is faster than is consistent with the BoC’s 2% inflation target. Labour costs haven’t been a major driver of inflation to date with pay gains barely keeping pace with the rising cost of living. But the BoC will want to see some of the heat coming out of Canada’s labour market to ensure wages are growing at a more sustainable pace.

…but GDP data suggests not for long

The labour market is a lagging indicator, so the BoC also needs to focus on GDP trends in deciding when to pause its tightening cycle. Canadian GDP growth was unexpectedly strong in Q3 with a nearly 3% annualized increase coming in well ahead of our forecast and the BoC’s. The surprise was due to upward revisions to monthly growth estimates over the summer—it remains the case that momentum has slowed in recent months with GDP edging up just 0.1% in

September and October’s flash reading coming in flat. Details of the Q3 increase left much to be desired with final domestic demand actually declining in the quarter. Consumer spending fell as a pullback in goods sales offset ongoing recovery in services spending, while housing remained a notable drag. Growth was driven entirely by further inventory accumulation (not a sustainable source of growth) and an increase in exports that will be tough to sustain in a challenging global growth environment. Housing is expected to remain a near-term drag and we think consumer spending growth will remain weak as debt servicing costs absorb a growing share of household income. We continue to look for slower growth in the final quarter of this year before Canada’s economy enters a recession in the first half of 2023.

US consumer showing resilience

Consumer spending, which represents two-thirds of the US economy, is showing surprising resilience in the face of tightening financial conditions. Inflation-adjusted spending rose an annualized 4.8% in the three months to October, the fastest pace in a year. But we think that momentum will be difficult to sustain. The recent increase in durables spending was driven by a jump in auto sales that was partially retraced in November. Higher interest rates will continue to make those big-ticket purchases less attractive. And recent spending growth has been funded by a decline in household savings. In fact, October’s 2.3% savings rate was one of the lowest on record as consumers dipped into excess savings accumulated during the pandemic. While there’s still a savings pool to draw from, weak consumer confidence and negative wealth effects (home prices have started to decline, on top of a sharp pullback in equity and bond markets this year) could make households less comfortable running down their rainy-day funds.

Real income growth has done little to support consumer spending—inflation-adjusted disposable income was actually down 3% year-over-year in October. While headline inflation has peaked, we see it continuing to exceed wage growth (which has been steady around 5%) through the first quarter of next year. And there are tentative signs that labour demand is softening, suggesting wage growth will also start to slow in 2023. While payroll gains have been stronger than expected—averaging 323,000 in the past six months—the separate household survey shows a sharp slowing with average employment gains of just 7,000 over that period. It’s worth noting that payrolls tend to be slower to respond to turning points in the labour market. Jobless claims have ticked higher in recent weeks, and the Fed’s latest Beige Book noted scattered layoffs in sectors like tech, finance and real estate. Labour markets were still described as tight though some districts saw some relaxation of wage pressures.

Fed ready to slow its tightening cycle

In a late-November speech, Chair Powell discussed easing in core goods inflation and early signals that housing services inflation will eventually turn disinflationary. But he noted only tentative signs of rebalancing in the labour market, with wages still rising significantly faster than is consistent with 2% inflation. With labour costs being a key driver of inflation in core services ex housing, Powell said the Fed has “a long way to go in restoring price stability.” He reiterated his view that interest rates will have to move higher than the Fed’s dot plot suggested in September (when all participants saw the terminal fed funds rate below 5%). But minutes from the November meeting show that view was only shared by “various” participants, suggesting upward revisions to December’s dot plot might not be so widespread.

The minutes also showed “a substantial majority of participants” thought it would soon be appropriate to slow the pace of rate hikes, cementing market expectations (and our own) for a 50 bp increase in December. After that we see the Fed delivering some further tightening in early-2023 but hitting pause as economic and inflation data show greater evidence of slowing. The Fed has emphasized that interest rates will have to be held “at a restrictive level for some time,” but we think cuts are likely in the later stages of 2023. As market focus shifts from near-term hikes to eventual easing, we see Treasury yields drifting lower next year and some of the current yield curve inversion (which has deepened in recent months) being unwound over the next year.

UK recession underway amid challenging consumer outlook

UK GDP fell 0.2% (non-annualized) in Q3, kicking off what we expect will be a recession that extends into the second half of next year. Some of the Q3 pullback reflected an extra public holiday, though a half percent decline in household spending was greater than that factor alone would suggest. Consumers are clearly feeling the pinch of sharply rising inflation. Even with the government’s energy price guarantee partially shielding households from market prices—without it, CPI would be running at 13% rather than today’s 11%—real pay growth is still deeply negative. And consumer confidence is now weaker than it was in the depths of the pandemic and global financial crisis, despite record low unemployment. While we think inflation has peaked, it’s likely to decline more slowly than in other advanced economies as energy support becomes less generous in the spring—headline inflation isn’t expected to slow below 4% until 2024.

We look for the BoE to revert to a 50 bp hike in December (November’s 75 bps was a one-off) and think the central bank will opt for another 25 bp increase in February before hitting pause on its tightening cycle with the Bank Rate at 3.75%. The impact of that tightening will continue to build in 2023. The BoE estimates around one quarter of mortgages will reach the end of their fixed-rate term between the current quarter and the end of next year, which will mean a significant increase in mortgage costs. A debt servicing hit combined with ongoing cost of living challenges should result in mild GDP declines continuing over the first half of next year.

Surveys point to euro area slowdown heading into 2023

Euro area PMI data continue to suggest the currency bloc’s economy began to slow in Q4 with both manufacturing and services indices in contractionary territory. Consumer confidence has ticked up in the past two months but remains deeply depressed. Sentiment was dealt a blow early in the year with Russia’s invasion of Ukraine, and has soured further as energy prices pushed inflation to multi-decade highs. Headline inflation is likely past its peak but remained at 10% in November, running well ahead of wage growth. This cost of living shock is expected to weigh on consumer spending, resulting in GDP declines in the current quarter and early next year. We expect this slowdown will begin to ease as inflation moderates, and increased fiscal support from the NextGenerationEU (NGEU) recovery plan will help.

We look for a 50 bp hike by the ECB in December, lifting the deposit rate to 2% which we think is close to neutral. We expect rate hikes to continue at a slower pace in the first quarter of 2023 before the ECB hits pause after its March meeting. The central bank is already shrinking its balance sheet through TLTRO redemptions, and we expect it will add to that by beginning to reduce its APP holdings next spring, shortly after its final rate hike. We should get details from the ECB at its upcoming meeting but at this stage expect passive QT by limiting reinvestment rather than outright asset sales.

RBA not ready to hit pause just yet

Australia’s economy continued to expand at a steady pace with Q3 GDP rising 0.6% (non-annualized) led by gains in consumer spending and business investment. The former was helped by further normalization in the household savings rate, although there is still little evidence of consumers dipping into the substantial savings accumulated during the pandemic. Housing has felt the greatest drag from rising rates—residential investment was down nearly 4% year-over-year in Q3—but we think the impact on consumer spending will mount as a relatively high share of variable rate mortgages accelerates pass-through of the RBA’s rapid rate hikes (+300 bps in the past eight months). As in other countries, consumer confidence has fallen sharply with rising borrowing costs and high inflation dampening any positive sentiment around a strong labour market. A moderation in consumer spending and further pullback in housing are central to our forecast for GDP growth to slow to 1.5% next year from 3.6% this year.

The RBA hiked by another 25 bps in December and left its forward guidance unchanged, suggesting it has no intention to pause its tightening cycle in the near term. However, the statement noted “substantial” tightening already delivered and lags in monetary policy transmission, in our view indicating a more data dependent approach with monetary policy now in restrictive territory. We look for a further 50 bps of hikes in Q1/23 but see the RBA pausing thereafter as the Australian economy’s recent resilience begins to fade.

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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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