Coming in for a landing?

Canada's real GDP rose 0.3 percent in April, according to data released this morning by Statistics Canada. Growth was broad-based, with thirteen of twenty sub-sectors reporting gains. Expansion was concentrated in the goods-producing sectors of the economy, which in aggregate gained 0.9 percent in the month, compared to only 0.1 percent for services. Mining, quarrying and oil and gas extraction were particularly strong, rising 3.3 percent in the month to stand 8.5 percent higher than a year ago. 

April's growth rate was down significantly from the 0.7 percent recorded in March, but that strong "handoff" from Q1, combined with the positive result for April, means that GDP growth for Q2 as a whole is likely to look healthy. That being said, StatsCan's preliminary read for GDP in May points to a 0.2 percent monthly decline, with output lower in mining, quarrying and oil and gas extraction (perhaps not surprising after the very strong data for April), as well as in manufacturing and construction. 

One data point cannot be taken to indicate a trend, but the flow of data on the real economy now merits close attention, given widespread fears over the impact of tighter monetary policy on both sides of the border.  The Toronto Star's business section ran an article earlier this week under the headline "Economists say a recession is unlikely -- but will it become a self-fulfilling prophecy"?  

It's tempting to say that the negative tone of business coverage in the Star and elsewhere in the media has every chance of making that happen. That being said, securities markets are certainly running scared right now, and stories about the sudden reversal in real estate markets and rising use of food banks are starting to pile up. Recession in the usual sense of two consecutive quarters of falling GDP still does not seem to be the likeliest outcome for Canada, but sluggish growth in output and some weakening in labour markets seem sure to happen in the second half of the year.  

Even worse than expected

Canada's headline CPI rose 7.7 percent in the year to May, up from 6.8 percent in April, according to new data released by Statistics Canada this morning. This was worse than the already-gloomy analysts' consensus, and represents the highest increase in overall consumer prices since January 1983. The month-on-month rise in prices was a startling 1.4 percent in May, up from 0.6 percent in April.

Gasoline and food prices continue to be the main drivers of headline inflation. Gasoline prices, which  rose 12 percent in May alone (48 percent year-on-year), were the largest single contributor to the monthly figure. Food prices rose 0.8 percent in the month for an annual increase of 8.8 percent, in line with the prior month's reading.

These may be the main culprits, but in truth inflation pressures are broad-based. All eight components tracked by StatsCan were higher on both an annual and a monthly basis in May. Excluding food and energy, CPI rose 0.9 percent in the month of May and 5.2 percent for the year, not numbers that can give any comfort to policymakers at the Bank of Canada as they pursue their 2 percent inflation target.

Speaking of the central bank, its preferred measures of core inflation also continued to misbehave in May. All three of these measures moved higher in May, with the mean reading rising yet again to stand at 4.7 percent, up from 4.4 percent in April.  It might be noted that every single measure of inflation, including these aggregates, stands well above the 3.9 percent increase in average hourly earnings; this is not (yet) a wage-price spiral. 

Gasoline prices have moved slightly lower across the country so far in June, which may provide some relief for headline CPI for the month. On the other hand, utilities are preparing to make major increases in natural gas prices, which have been relatively stable until now.  There is scant reason to expect any relief on the price front any time soon, so a further substantial rate increase from the Bank of Canada -- 50 or even 75 basis points -- looks to be locked in.  

75 today, and more to come

Market expectations that the Federal Reserve would hike the funds target rate by 75 basis points today -- the largest move in almost three decades -- have proven accurate. The new funds target range is 1.50 - 1.75 percent.  The FOMC statement expresses confidence that the brief downturn in growth seen in Q1 has given way to renewed expansion, while "Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures".

The rest of the boilerplate language in the statement is little changed from earlier meetings. The key takeaways are that "The Committee is strongly committed to returning inflation to its 2 percent objective", and that "The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals".  Only one FOMC member voted for a smaller (50 basis point) hike. 

The accompanying set of economic projections show some significant changes in the FOMC's outlook compared to just three months ago. The median projection for real GDP growth in 2022, at 1.7 percent, is more than a percentage point lower than the March projection, and expected growth rates for both 2023 and 2024 have also been revised lower. In effect, the Fed appears to be expecting growth to stabilize close to its estimated longer-run potential, which may bode well for prospects of getting inflation back to target. 

As for inflation, the median projection for the PCE (personal consumption expenditure) deflator in 2022 is now 5.2 percent, up from 4.3 percent in March. However, the FOMC still appears confident that PCE inflation will fall rapidly after this year: projections of 2.6 percent and 2.2 percent for 2023 and 2024 respectively are almost identical to the March figures. It should be noted that the more widely-followed CPI figures tend to track higher than PCE, so these projections do not suggest that headline inflation will be back to the 2 percent target until late 2024 at best. 

The most startling change in the Fed's economic projections relates to its interest rate outlook. The Fed funds rate projected for 2022 is now 3.4 percent, up fully 150 basis points from the March projection. A further rise to 3.8 percent is expected in 2023, before some relief arrives in 2024. These figures are all higher than recent estimates of the "neutral" funds rate, which have generally been in the 2.5-3.0 percent range. 

Taken together, all of this implies that the Fed believes it can continue to thread the needle policy-wise, raising rates enough to bring inflation down while keeping the economy out of recession. This points to further outsize increases in the funds target in the coming months. The goal is to keep inflation expectations in check while waiting for relief from the supply chain issues that are the main drivers of the ongoing inflation spike.  

It's all about debt

Amid mounting fears over just how far and how fast the Bank of Canada might raise interest rates, the Canadian media are suddenly full of scare stories about the financial plight of the household sector. On Monday Statistics Canada released data on national wealth and financial flows for the first quarter of the year, which provided fresh insights into household balance sheets. And on the same day, Manulife Bank of Canada released a survey outlining some scary scenarios if mortgage rates continue to rise. 

In many respects the StatsCan data paint a positive picture of household finances. The net worth of the household sector rose by about 1.2 percent in the first quarter, with higher non-financial assets (mainly real property) offsetting falls in the value of financial assets. The aggregate value of residential real estate rose by more than 10 percent in from Q3/2021 to Q1/2022. The household savings rate rose to 8.1 percent in Q1, the highest level since 1995 if you ignore the bloated levels briefly recorded early in the COVID pandemic. Lastly, the ratio of household debt to disposable income edged down to 182.5 percent in Q1 from the record 185.0 percent posted in the previous quarter; it need hardly be stated that this is still an extremely high ratio by global standards. 

If there are positives to be taken from the data, why is the media coverage so bleak?  In part this relates to the media's voracious appetite for bad news, and in part it reflects the sheer speed with which a multi-year sellers' market has U-turned into a buyer's market.  It is also important to keep in mind that the data are highly aggregated: the "average" household may be in fine shape, but there are many that are not. Those that stretched their borrowing to the limit in order to get into last year's hot housing market and also opted for a floating rate mortgage are particularly vulnerable -- and according to the StatsCan data, 30 percent of outstanding mortgages are at floating rates. 

It may be argued that the rising aggregate value of household net worth means the problem is not a serious one. This again ignores the risks now being faced by the most heavily indebted households. It also fails to recognize the distinction between bankruptcy and insolvency. A household with substantial equity in its home many not be at risk of going bankrupt, but it may still lose the home if its cashflow becomes insufficient to service its mortgage debt.  

This brings us to the Manulife survey, which polled 2000 households across Canada in mid-April. Here are the key conclusions:

• Nearly 25% of homeowners say if interest rates increase further, they’d be forced to sell.
• 1 in 5 homeowners believe they can no longer afford the house they own.
• Nearly half of Canadians said they would struggle to handle unexpected expenses.
• NEARLY 40% of Canadians do not feel like their wages are keeping up with inflation.
• 80% of Canadians think there is an affordability crisis in Canada.

This is all quite remarkable, particularly as the Bank of Canada had only just started its tightening cycle when the survey was conducted. For anyone who carried a mortgage at a rate well above 10 percent in decades past, it's hard to grasp that current interest rates have pushed so many Canadian households so rapidly to the point of despair.  Interestingly, Manulife Bank itself -- in sharp contrast to the media latching on to the story -- is cautious in interpreting the data. Here is its "key takeaway" from the report:

With the shift in the housing market, rising interest rates and inflation concerns, it’s normal to worry about your long-term financial future. But feeling like you can’t afford your home doesn’t mean you’ll be forced to sell if interest rates continue to rise. Once you know more about how interest rates work, you’ll have a better idea of how this may impact you and will help you feel more in control when it comes time to make any major financial decisions.

That seems like excellent advice, though no doubt too late for many people. Experts have been fretting for years about what might happen when the Canadian housing market stopped racing ahead. We're starting to find out, and it doesn't look as if it will be very pretty to watch. 

Canadian recession? Also Nope!

The Canadian jobs market remains remarkably strong. Data released today by Statistics Canada show that the economy added 40,000 jobs in May, dropping the national unemployment rate to an all-time low of 5.1 percent. Details of the release paint a somewhat more mixed picture than the headline, but there is little evidence that the economy faces any imminent risk of a downturn.

Full-time employment rose more than 135,000 in the month, offset by a fall of almost 96,000 in part-time positions. Employment in Canada now stands almost 500,000 above its pre-pandemic level, a remarkable contrast to the US, where employment remains below its early 2020 peak. The gains in May were mainly in public sector employment and were concentrated in the service sector, with goods-sector employment significantly lower. The increase in employment was also very uneven geographically: Alberta, embarking on something of a boom as oil prices surge, accounted for 28,000 of the job gains in the month.

Even with these caveats as to the details of today's report, there is nothing here to challenge the Bank of Canada's oft-repeated view that the economy is operating at full employment. The Bank will also be keeping a wary eye on the trend in wages. The year-on-year increase in average hourly earnings rose to 3.9 percent in May from 3.3 percent in April. While this remains well below the 6.8 percent increase in CPI, it will heighten concern at the Bank that wage could start to aggravate the existing supply-driven inflationary pressures.

This points unerringly towards another 50 basis point rate hike at the Bank's next policy adjustment data in July. And, as with the Federal Reserve, one can only bemoan the fact that the tightening cycle was not initiated just a little bit earlier. 

Transitory inflation? Nope.

There had been some hope that US consumer price inflation had reached a peak in April, when the month-on-month increase was a modest 0.3 percent. However, data released this morning by the Bureau of Labor Statistics showed a 1.0 percent jump in headline CPI for May, which propelled the year-on-year gain to 8.6 percent, the highest figure recorded since December 1981. 

Energy and food prices continue to be the main drivers of the rise in headline CPI, and with no sign of any end to the war in Ukraine, supply-driven pressures on those key items are unlikely to ease any time soon. Energy prices rose 3.9 percent in the month, bringing the yearly increase to 34.6 percent. For food, the corresponding numbers are 1.2 percent and 10.1 percent. Even excluding these items, however, there is plenty of evidence that the current inflation spike is broad-based. The index for all items less food and energy rose 0.6 percent in the month, the same as in April, to stand 6.0 percent higher than in May 2021. 

Major retailers are starting to bemoan rising inventories as consumers rein in discretionary spending, and this may translate into price reductions in the coming months. However, gasoline prices have hit fresh all-time record highs yet again in the first part of June, so the all-items index is likely to stay at or close to its May level for at least another month or two.

Equity markets sold off sharply on this morning's news, reflecting investor fears that the data might push the Fed into a 75 basis point rate hike at next week's two-day FOMC meeting. This cannot be altogether ruled out, but the Fed is acutely aware that it cannot directly do very much about the current inflation spike, given that it originates on the supply side of the economy.  A further 50 basis point hike remains the most probable outcome, accompanied by more tough rhetoric about the need for more tightening, in the increasingly vain hope of keeping inflation expectations under control. 

The job would have been so much easier if the Fed had acted on the hawkish rhetoric it adopted six months ago and started the tightening cycle a month or two earlier. Hindsight is wonderful, of course, but there were plenty of people saying that at the time. Oh well.  

Same song, different key

The Bank of Canada issued its 2022 Financial System review this morning. Governor Tiff Macklem and Senior Deputy Governor Carolyn Rogers met with the media to discuss the key findings, with a particular focus on what the Bank sees as the principal vulnerabilities in the Canadian financial system. 

Unsurprisingly the number one area of concern is, as it has been for many years now, the elevated level of house prices and the associated rise in household debt. Ultra low interest rates triggered by the COVID pandemic induced a large number of Canadians to take on substantial amounts of debt to acquire a home, which naturally drove up house prices, by as much as 50 percent.  Even the modest rate hikes implemented by the Bank so far this year have been sufficient to trigger an abrupt change from a seller's market to a buyer's market in many parts of the country, underscoring the Bank's concern. 

The Bank acknowledges the "remarkable" improvement in overall household savings and wealth during the pandemic, but then quickly moves on to emphasize the vulnerability of certain homeowners: 

....even as the average household is in better financial shape, more Canadians have stretched to buy a house during the pandemic. And these households are more exposed to higher interest rates and the potential for housing prices to decline.....Throughout the pandemic, a growing number of Canadians took out mortgages that were very large relative to their incomes, at variable rates with amortization periods of more than 25 years. And our models suggest that the most highly indebted households saw only a small increase in their liquid assets in that time.

The Bank acknowledges that vulnerability may at some point constrain its efforts to bring inflation back to the 2 percent target:

With inflation well above the 2% target and the Canadian economy overheating, the Bank’s number one priority is to get inflation back to target, and we are raising interest rates to make that happen....The economy can handle—indeed needs—higher interest rates.... If the economy slowed sharply and unemployment rose considerably, the combination of more highly indebted Canadians and high house prices could amplify the downturn....Were this to affect many households, it could have broad implications for the economy and financial system. This is not what we expect to happen. Our goal is for a soft economic landing with inflation coming back to the 2% target. But it is a vulnerability to watch closely and manage carefully.

In short, the Bank thinks it can engineer a soft landing as it brings inflation down, but it is by no means certain of that. 

The opening statement goes on to talk in much less detail about three other vulnerabilities. Two of these are predictable enough: the war in Ukraine, with its potential for cybersecurity threats, and the transition to a low-carbon economy, which may abruptly reprise financial and real assets. The third is a bit more novel:

Finally, cryptoassets are a growing vulnerability. More Canadians are investing in cryptocurrencies. But the growth of these markets has outpaced global efforts to regulate them. Like other speculative assets, cryptocurrencies are vulnerable to large and sudden price declines. And recently, some stablecoins—a type of cryptocurrency—have failed to deliver on their promise of stability. While cryptoassets do not yet pose a systemic risk to the Canadian financial system, the lack of regulation means they don’t have the safeguards that exist for more traditional assets. And their risks may not be well-understood by investors. Regulators around the world and in Canada have recognized this risk and are working to address it.

Given the collapse in crypto "asset" values in the last couple of months, this is a timely warning, especially as the statement that "their risks may not be well-understood by investors" is almost certainly a colossal understatement. 

All in all, then, plenty for the Bank of Canada to keep a wary eye on -- but as always, it is the housing market that seems to warrant the most concern.   

Ford drives on

I haven't bothered until now to post anything about the Ontario Provincial election campaign, which ended yesterday with a thumping victory for the Conservatives and their lumpen leader, Doug Ford. The election campaign was marked by a profound lack of engagement on the part of the electorate, which was duly reflected in a 43 percent turnout at the polls, by far the lowest ever. There seemed to be little reason to inflict any of this of the faithful readers of this blog. 

By and large the media don't much like Doug Ford. He's not one for making public appearances all over the place in order to maintain a high profile with the voters. He campaigned much less actively than his opponents this time out, and yet still managed to increase both his party's share of the vote and its representation in the Provincial legislature at Queen's Park.

The sour grapes in the media began even before the votes were tallied, because it was very obvious early on that neither the Liberals nor the New Democrats were going to lay a glove on the Tories.  Pundits suggested the public indifference to the whole event was playing into Ford's hands, but isn't that kind of missing the point? It's rarely if ever up to the incumbent government to inject excitement into an election campaign. The incumbent will always be judged primarily on its track record. It's up to the opposition parties to get the fireworks going, and the ultra-low turnout yesterday shows that they entirely failed to do so.

The leaders of the two largest opposition parties have already paid the price of failure, with both quitting even before all the votes were tallied. This was NDP leader Andrea Horwath's fourth election at the helm. Although her party retained its status as official opposition, she has chosen to make way for new blood, but given that she has been the face of the party since 2010, it may be hard to find a replacement with any kind of public profile. As for the Liberals, it says it all that their leader, Steven Del Duca, was not a member of the legislature before the election, and failed to win a riding he has lived in for many years. The party won so few seats that it will not have official party status going forward. There are unlikely to be many takers for the leadership.

We have to spend a moment to consider the role of the Toronto Star, Canada's highest-circulation newspaper, in all of this.  The Star hates all Tories but has a particularly strong animus for Doug Ford. When the COVID pandemic arrived, the Star chose to have one reporter -- Bruce Arthur, notionally a sports columnist -- focus on nothing but COVID, with a barely concealed mandate to blame absolutely everything on Ford. 

So much for that. Although there was plenty to criticize about how Ford handled COVID, it would be hard to argue that he did a worse job than anyone else in a similar position, and Bruce's incessant carping may well have turned a lot of people off.  In the wake of the election Bruce is calling for reform of Ontario's first past the post electoral system, in order to prevent the Tories from winning thumping majorities with only 40 percent of the vote.  Similar concerns were not often heard from the Star earlier in this century, when the Liberals racked up fifteen consecutive years in office. 

Four more years of Ford is not something we can look forward to. His team are mostly a graceless lot and some of his election pledges, notably an expensive and unnecessary new highway for the Greater Toronto area, are very bad indeed. But his success yesterday can have come as no surprise to anyone who had been paying attention. What's more, given the leadership vacuum on the Liberal and NDP benches, you would already make the Tories favourites for the 2026 election -- maybe under the leadership of Doug's nephew Michael, who was elected for the first time yesterday. 

The best surprise is no surprise

That decades-old slogan from Holiday Inn seems lie the best way to summarize today's Bank of Canada rate decision.  Prompted by weeks of heavy hints from the Bank, markets had priced in a 50 basis point rate hike, and that is exactly what the Bank delivered, along with a continuation of its quantitative tightening program. The overnight rate target is now 1.5 percent, a scant 25 basis points below its pre-pandemic level.

Given that the immediate rate decision was no surprise to anyone, the interest in the Bank's media release centres mainly on any hints it may offer about what comes next. The answer: more rate hikes. It is very clear that for now, the Bank is a lot more concerned about above-target inflation than about any near-term deceleration in economic activity. 

Inflation globally and in Canada continues to rise, largely driven by higher prices for energy and food. In Canada, CPI inflation reached 6.8% for the month of April – well above the Bank’s forecast – and will likely move even higher in the near term before beginning to ease. As pervasive input price pressures feed through into consumer prices, inflation continues to broaden, with core measures of inflation ranging between 3.2% and 5.1%. Almost 70% of CPI categories now show inflation above 3%. The risk of elevated inflation becoming entrenched has risen. The Bank will use its monetary policy tools to return inflation to target and keep inflation expectations well anchored.

Canadian economic activity is strong and the economy is clearly operating in excess demand. National accounts data for the first quarter of 2022 showed GDP growth of 3.1 percent, in line with the Bank’s April Monetary Policy Report (MPR) projection. Job vacancies are elevated, companies are reporting widespread labour shortages, and wage growth has been picking up and broadening across sectors. Housing market activity is moderating from exceptionally high levels. With consumer spending in Canada remaining robust and exports anticipated to strengthen, growth in the second quarter is expected to be solid.

That all seems clear enough. It seems almost inevitable that the next Governing Council meeting, set for July 13, will bring another 50 basis point rate hike. The Bank will also release an updated Monetary Policy Report on that day, which should provide better insight into what lies ahead. A fourth 50 bp rate increase later in the year would bring the target rate to 2.5 percent, which would be in the range that the Bank regards as neutral; it seems unlikely that the tightening process would stop before that level is reached. For the avoidance of doubt, however, the Bank ended today's release by re-using a word that has become a major part of its lexicon in recent months:  Governing Council is prepared to act more forcefully if needed to meet its commitment to achieve the 2% inflation target. Best to assume they mean it.