Uncertainty: Everywhere and All at Once
United States
Along with stubborn inflation and the Ukraine war, a new threat to the economy has emerged. The failure of three regional banks and the fire sale of Credit Suisse have sent tremors across global financial markets. While regulators quickly acted to ringfence the fallout, investors remain on edge. For now, the Fed's new lending facility, which allows banks to borrow funds for up to a year by pledging securities at par, appears to have steadied market nerves.
Even in the absence of broader contagion, the economy will feel the effects of financial stress. Although Treasury yields have fallen sharply due to safe-haven demand and an expected earlier Fed pivot, financial conditions have tightened on wider corporate credit spreads and a firmer greenback. While borrowing costs have fallen for governments, that may not be the case for businesses and households. Lending standards, which were already tightening, will become more restrictive, constraining credit. Smaller banks have been a key source of funding for commercial real estate, dealing another blow to the office segment that is struggling to deal with remote working. Consumer and business confidence will be hit, slowing job growth.
The fallout will test the economy's resilience and increases the odds on our call for a mild, two-quarter recession this year. We still see real GDP expanding just 0.7% in all of 2023, down from 2.1% last year, before picking up to 1.3% in 2024. The unemployment rate is expected to rise more than one percentage point to 4.8% at year-end, before retracing somewhat next year.
The economy's resilience, so far, is driven by households. Consumer spending likely strengthened to around 3% annualized in Q1. A mild winter has helped, but spending was also buffered by stunningly strong job growth (over 800,000 new payrolls in the past two months), continued spending of pandemic savings, and lingering demand for deferred services. We estimate that the latter two pillars could support demand for the remainder of the year, limiting the severity of a downturn. Still, consumers will likely pull back due to higher interest rates and the fallout from the banking stress. Businesses should also turn cautious on spending and hiring. While the downturn in home sales appears to have steadied due to lower mortgage rates, activity will remain depressed in a slumping economy. Home prices, which have retraced just a fraction of their earlier record rise, will decline further to support affordability.
Recession is the timeworn cure for high inflation. While the annual CPI rate has fallen from four-decade highs of 9.1% last summer to 6.0% in February, the core rate (ex-food and energy) is proving much stickier, slipping from 6.6% to 5.5% and still running 5.2% annualized in the past three months. Cheaper gasoline explains the faster decline in the headline rate, and a further slide in oil pries below $70 (the lowest since late 2021) is encouraging. Meantime, global supply chain pressures have normalized after three years of disruptions and delays, according to the New York Fed. Still, minimal slowing in wage growth suggests prices in the labour-intensive service sector will continue to run hot for a while, keeping inflation perched above 3% at year-end.
The Fed's mandate to maintain financial stability will take precedence over its price stability goal. A day before the recent banking stress broke, the Chair warned Congress about possibly needing to speed up the pace of rate hikes at the next policy meeting. That decision depended largely on the outcome of a few key data points. But despite an even peppier core inflation rise and another large jobs gain in February, Powell's threat is likely off the table for now. The FOMC could deem the economic risks have shifted to the downside due to the turmoil. We still lean slightly toward a 25 bp increase on March 22, but the situation is very fluid.
Canada
Like its major trading partner, Canada's economy bolted out of the gates this year. In January, employment rose the most on record (outside the pandemic) and remained solid in February. Factory shipments shot 4% higher in January, implying some upside to StatCan's preliminary estimate of a 0.3% rebound in real GDP. Existing home sales climbed the most in a year in February, benefiting from lower prices and the central bank's pause signal. While sales are still down 40% y/y, they look to have bottomed. The robust data partly reflect milder temperatures, but excess household savings also help. After real GDP stalled in Q4 due to a large decline in business spending and less inventory investment, the economy likely turned upwards in Q1.
While credit conditions should tighten less in Canada than stateside, the economy is unlikely to avoid a mild downturn. The global financial stress will have knock-on effects for domestic businesses. While interest rates haven't risen as much as in the U.S., households are more sensitive due to larger debts and shorter mortgage terms. With policy rates now the highest since 2007, many younger mortgage holders haven’t experienced high borrowing costs and will be compelled to cut back on discretionary spending. Consequently, real GDP growth is expected to decelerate to 0.7% in 2023 from 3.4% last year, before expanding 1.3% in 2024. The unemployment rate should rise about one percentage point to 5.9% at year-end, a modest increase compared with past recessions.
Inflation continues to fall. After poking its head above 8% last summer, the annual CPI rate fell to 5.9% in January, with the 3-month trend of several core metrics at 3 1/2% or less. While labour markets remain tight, debt-laden consumers seem to be pushing back at price hikes. We expect inflation to ease to around 3% at year-end, skirting the top end of the central bank's control range.
As expected, the Bank of Canada held policy rates steady at 4.5% in March, sticking with its earlier guidance to pause and assess the impact of past actions on the economy. Still, the Bank underscored the conditional nature of its decision, warning that either stronger growth or stickier inflation could pull it off the sidelines. The recent financial turmoil, however, should dissuade any thoughts of hiking on April 12. We still expect no further policy changes this year, with rate cuts likely to begin by early next year.
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Sal Guatieri
Senior Economist
Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with two decades experience as a macro economist. With BMO Financial Group since 1994, his m…(..)
View Full Profile >United States
Along with stubborn inflation and the Ukraine war, a new threat to the economy has emerged. The failure of three regional banks and the fire sale of Credit Suisse have sent tremors across global financial markets. While regulators quickly acted to ringfence the fallout, investors remain on edge. For now, the Fed's new lending facility, which allows banks to borrow funds for up to a year by pledging securities at par, appears to have steadied market nerves.
Even in the absence of broader contagion, the economy will feel the effects of financial stress. Although Treasury yields have fallen sharply due to safe-haven demand and an expected earlier Fed pivot, financial conditions have tightened on wider corporate credit spreads and a firmer greenback. While borrowing costs have fallen for governments, that may not be the case for businesses and households. Lending standards, which were already tightening, will become more restrictive, constraining credit. Smaller banks have been a key source of funding for commercial real estate, dealing another blow to the office segment that is struggling to deal with remote working. Consumer and business confidence will be hit, slowing job growth.
The fallout will test the economy's resilience and increases the odds on our call for a mild, two-quarter recession this year. We still see real GDP expanding just 0.7% in all of 2023, down from 2.1% last year, before picking up to 1.3% in 2024. The unemployment rate is expected to rise more than one percentage point to 4.8% at year-end, before retracing somewhat next year.
The economy's resilience, so far, is driven by households. Consumer spending likely strengthened to around 3% annualized in Q1. A mild winter has helped, but spending was also buffered by stunningly strong job growth (over 800,000 new payrolls in the past two months), continued spending of pandemic savings, and lingering demand for deferred services. We estimate that the latter two pillars could support demand for the remainder of the year, limiting the severity of a downturn. Still, consumers will likely pull back due to higher interest rates and the fallout from the banking stress. Businesses should also turn cautious on spending and hiring. While the downturn in home sales appears to have steadied due to lower mortgage rates, activity will remain depressed in a slumping economy. Home prices, which have retraced just a fraction of their earlier record rise, will decline further to support affordability.
Recession is the timeworn cure for high inflation. While the annual CPI rate has fallen from four-decade highs of 9.1% last summer to 6.0% in February, the core rate (ex-food and energy) is proving much stickier, slipping from 6.6% to 5.5% and still running 5.2% annualized in the past three months. Cheaper gasoline explains the faster decline in the headline rate, and a further slide in oil pries below $70 (the lowest since late 2021) is encouraging. Meantime, global supply chain pressures have normalized after three years of disruptions and delays, according to the New York Fed. Still, minimal slowing in wage growth suggests prices in the labour-intensive service sector will continue to run hot for a while, keeping inflation perched above 3% at year-end.
The Fed's mandate to maintain financial stability will take precedence over its price stability goal. A day before the recent banking stress broke, the Chair warned Congress about possibly needing to speed up the pace of rate hikes at the next policy meeting. That decision depended largely on the outcome of a few key data points. But despite an even peppier core inflation rise and another large jobs gain in February, Powell's threat is likely off the table for now. The FOMC could deem the economic risks have shifted to the downside due to the turmoil. We still lean slightly toward a 25 bp increase on March 22, but the situation is very fluid.
Canada
Like its major trading partner, Canada's economy bolted out of the gates this year. In January, employment rose the most on record (outside the pandemic) and remained solid in February. Factory shipments shot 4% higher in January, implying some upside to StatCan's preliminary estimate of a 0.3% rebound in real GDP. Existing home sales climbed the most in a year in February, benefiting from lower prices and the central bank's pause signal. While sales are still down 40% y/y, they look to have bottomed. The robust data partly reflect milder temperatures, but excess household savings also help. After real GDP stalled in Q4 due to a large decline in business spending and less inventory investment, the economy likely turned upwards in Q1.
While credit conditions should tighten less in Canada than stateside, the economy is unlikely to avoid a mild downturn. The global financial stress will have knock-on effects for domestic businesses. While interest rates haven't risen as much as in the U.S., households are more sensitive due to larger debts and shorter mortgage terms. With policy rates now the highest since 2007, many younger mortgage holders haven’t experienced high borrowing costs and will be compelled to cut back on discretionary spending. Consequently, real GDP growth is expected to decelerate to 0.7% in 2023 from 3.4% last year, before expanding 1.3% in 2024. The unemployment rate should rise about one percentage point to 5.9% at year-end, a modest increase compared with past recessions.
Inflation continues to fall. After poking its head above 8% last summer, the annual CPI rate fell to 5.9% in January, with the 3-month trend of several core metrics at 3 1/2% or less. While labour markets remain tight, debt-laden consumers seem to be pushing back at price hikes. We expect inflation to ease to around 3% at year-end, skirting the top end of the central bank's control range.
As expected, the Bank of Canada held policy rates steady at 4.5% in March, sticking with its earlier guidance to pause and assess the impact of past actions on the economy. Still, the Bank underscored the conditional nature of its decision, warning that either stronger growth or stickier inflation could pull it off the sidelines. The recent financial turmoil, however, should dissuade any thoughts of hiking on April 12. We still expect no further policy changes this year, with rate cuts likely to begin by early next year.
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