No imminent recession in Canada

In recent week the Canadian media have been all but gagging for the economy to go into a recession, and doing their level best to talk it into one*. You're going to have to wait a little longer, guys! Statistics Canada announced this morning that real GDP was unchanged in May, and its preliminary estimate points to 0.1 percent growth in June.  If this latter figure is confirmed when the final data are computed, it would mean that real growth on a quarterly basis actually accelerated from Q1 to Q2, in sharp contrast to what's happening south of the border. 

The sectoral breakdown reveals that fourteen of the twenty sub-sectors tracked by StatsCan recorded higher output in May, led by the services sector. Goods producing sectors as a whole saw lower output, with manufacturing down by 1.7 percent, led by declines in production of durable goods.  This was the  first decline in manufacturing output in eight months, but the preliminary data for June appear to show an immediate rebound. 

The oldest saying in Canadian economics is that when the US sneezes, Canada gets pneumonia.  The apparent onset of a mild recession in the US, confirmed by yesterday's GDP data, is certainly cause for concern. However, the unusual make-up of the decline in US GDP, centered on inventory adjustment and public sector spending, may mean that Canada will largely be spared this time around, as long as US consumption continues to grow. What is quite certain is that there is nothing in today's numbers to deter the Bank of Canada from continuing its efforts to bring inflation back towards the 2 percent target. 

* Think I'm exaggerating? Check this out. 

Time to call a spade a shovel

The US Bureau of Economic Analysis announced this morning that real GDP declined at a 0.9 percent annualized rate in the second quarter of the year. Since that's an advance estimate that will be revised twice in the weeks ahead, it amounts to little more than a rounding error. Still, coming after a 1.6 percent fall in Q1, it means that the US economy has now met the most commonly-used definition of a recession: two consecutive quarters of falling real GDP.

Official pronouncements out of Washington this week amounted to a heads-up about what today's data would show. First there was a bizarre attempt by a White House spokesman to move the goalposts on the definition of a recession; this was not a good idea. Then just yesterday, the FOMC statement accompanying the latest interest rate hike conspicuously focused only on the strong labour market as evidence of the robust economy, with no mention of other indicators.

Today's number does not show widespread weakness in the US economy. Much of the decline reflected inventory adjustments, as companies continue to struggle to balance supply and demand in the wake of the pandemic. There were also declines in government spending at both Federal and local levels, as well as in fixed investment. Importantly, personal consumption, which is always the major driver of US economic activity, rose in the quarter, as did exports. 

As the White House tried to point out ahead of the numbers, the call on whether the US is in recession is actually made by the National Bureau of Economic Research. That august body likes to take its own sweet time to make the call, and uses more criteria than just the "two consecutive quarters of decline" rule. Even so, that rule has become so entrenched in recent times that we may as well just accept that as far as most people are concerned, the recession is indeed here.

So how long will it last, and how bad is it likely to get?  It is important not to take too much comfort from the jobs market data, as the FOMC seems to be doing. Employment tends to be a lagging indicator of activity, so if GDP has indeed been falling since some time in Q1, then jobs numbers may be about to take a turn for the worse right about now. This makes the July non-farm payrolls data, due on August 5, a key data point to watch.

What would turn a minor downturn into a real problem for policymakers (and politicians) would be any sign that consumer spending is about to turn lower.  Inflation is the number one economic issue on the mind of Americans right now, and the rapid erosion of purchasing power is already set to take a bite out of non-essential purchases as consumers are forced to spend more on essentials such as food and gasoline. This underscores the importance of keeping inflation expectations under control, so that consumer confidence is not severely eroded. Perverse as it sounds, the steep rate rises seen in the last two months might represent the Fed's best shot at ensuring that the recession remains short and shallow.

Fed moves closer to neutral, but will that be enough?

Is the US economy already in recession? We will find out tomorrow (Thursday) whether GDP declined in Q2 for the second straight quarter, meeting the commonly-used (if not exactly official) definition of a recession. It's quite certain that the Federal Reserve already knows what the data will reveal, but whatever that may be, it has not been deterred from a further aggressive rate hike. As expected, today's FOMC meeting ended with a 75 basis points hike in the funds target range, which now stands at 2.25-2.30 percent. 

The FOMC press release is sparse to the point of being minimalist. It acknowledges that "recent indicators of spending and production have slowed", but stresses that job gains are strong and the unemployment rate remains low.  Does this form of words hint that Q2 GDP will indeed be negative? Tomorrow will tell.

As for inflation, the FOMC says it is "highly attentive" to inflation risks. It points to pandemic related imbalances, higher food and energy prices and "broader price pressures" as areas of concern. It remains "strongly committed" to restoring inflation to the 2 percent target, and so expects that "ongoing increases in the target range will be appropriate", as well as further shrinkage of the Fed's own balance sheet. 

By raising rates by 150 basis points over the course of two meetings, the FOMC has moved monetary policy much closer to what would be considered a "neutral" level in more normal economic times.  This might suggest that future increases will be smaller, but having waited so long to start the tightening cycle, the FOMC can not be sure that it has done enough to curb inflation expectations and restore the credibility of its policy stance.  

The Q2 GDP data and the ever-approaching mid-term elections will also have to enter into the Fed's thinking in the coming weeks.  There are two more FOMC meetings, plus an early look at Q3 GDP data and three more CPI reports, between now and the mid-terms. President Biden will no doubt be looking at the data flow just as closely as the FOMC as November draws closer.  

Less worse than expected

You can't say you weren't warned -- and by Bank of Canada Governor Tiff Macklem, no less.  The Governor suggested last week, based no doubt on a heads-up from Statistics Canada, that headline inflation likely headed north of 8 percent in June, and might remain there for a few months before starting to slip lower.  

Sure enough, today's data from StatsCan showed that headline CPI rose 8.1 percent in the year to June, up from 7.7 percent in May, marking yet another four-decade high. This was actually a slightly better outcome than the market consensus, which had looked for an 8.4 percent increase.  That said, the month-on-month increase of 0.7 percent annualizes to an even higher rate than today's headline print, offering little grounds for optimism of any early improvement.

No prizes for guessing that the main culprits continue to be gasoline and food prices. Gasoline cost 55 percent more last month than it had in June 2021, while food prices stood 8.8 percent higher. Excluding gasoline, the annual rise in CPI was 6.5 percent; excluding both energy and food, it was 5.3 percent. While less scary than the headline, these figures are of course far above the Bank of Canada's 2 percent target. It might also be noted that seven of the eight components of the index tracked by StatsCan rose in June, the sole exception being clothing and footwear, so inflation pressures are undoubtedly broad-based. 

There are some positive signs to be found behind the headline. The month-on-month rise in food prices was only 0.1 percent, which may be explained mainly by seasonal factors. The three Bank of Canada measures of core inflation, which have been moving steadily higher for many months, were much better-behaved in June, although their mean value crept up to 5.0 percent for the first time. 

Looking ahead, the July data may look slightly more encouraging. Gasoline prices have been significantly lower all across the country so far in the month, while the availability of domestic produce should again translate into moderation in food prices.  The problem for policymakers is that the unexpected persistence of high inflation means that an elevated year-on-year headline CPI is effectively baked in for some months to come -- the so-called base effect. Even several months of low month-on-month prints will only gradually reduce the year-on-year headline numbers that inevitably attract the focus of the media.  

What this means is that going forward, the most useful indicator of the inflation outlook will be the month-to-month changes rather than the headline. The Bank of Canada will no doubt focus closely on this, as will your trusty blogger. Whether the media can be persuaded to look beyond the scary headline numbers is, alas, another story. 

To boldly go

Expectations for the outcome of today's Bank of Canada Governing Council meeting were steadily hardening as the big day loomed. Markets were largely pricing in a 75 basis point rate hike, matching the most recent move by the US Federal Reserve. In the event, the Bank went even further, raising official rates by a full percentage point; the overnight rate target now stands at 2.5 percent. This is the largest single increase in the target since 1998. 

The press release announcing the move is very clear about the reasoning. The final paragraph begins thus: 

With the economy clearly in excess demand, inflation high and broadening, and more businesses and consumers expecting high inflation to persist for longer, the Governing Council decided to front-load the path to higher interest rates by raising the policy rate by 100 basis points today. (Emphasis mine).

The body of the release, which is longer than usual, spells out the logic in more detail. (And there is even more detail to be found in the Monetary Policy Report, also released today). Some highlights:

As regards domestic inflation, the Bank is concerned about both the broadening of current price pressures and the evidence that inflation expectations are rising:

Inflation in Canada is higher and more persistent than the Bank expected in its April Monetary Policy Report (MPR), and will likely remain around 8% in the next few months. While global factors such as the war in Ukraine and ongoing supply disruptions have been the biggest drivers, domestic price pressures from excess demand are becoming more prominent. More than half of the components that make up the CPI are now rising by more than 5%. With this broadening of price pressures, the Bank’s core measures of inflation have moved up to between 3.9% and 5.4%. Also, surveys indicate more consumers and businesses are expecting inflation to be higher for longer, raising the risk that elevated inflation becomes entrenched in price- and wage-setting. If that occurs, the economic cost of restoring price stability will be higher.

As for real activity, the Bank sees strength just about everywhere it looks, resulting in excess demand and tight labour markets:

Further excess demand has built up in the Canadian economy. Labour markets are tight with a record low unemployment rate, widespread labour shortages, and increasing wage pressures. With strong demand, businesses are passing on higher input and labour costs by raising prices. Consumption is robust, led by a rebound in spending on hard-to-distance services. Business investment is solid and exports are being boosted by elevated commodity prices. The Bank estimates that GDP grew by about 4% in the second quarter. Growth is expected to slow to about 2% in the third quarter as consumption growth moderates and housing market activity pulls back following unsustainable strength during the pandemic.

In terms of its economic projections, the Bank expects growth to slow without the economy tipping into recession, but acknowledges that inflation will not return to target for another two years:

The Bank expects Canada’s economy to grow by 3½% in 2022, 1¾% in 2023, and 2½% in 2024. Economic activity will slow as global growth moderates and tighter monetary policy works its way through the economy. This, combined with the resolution of supply disruptions, will bring demand and supply back into balance and alleviate inflationary pressures. Global energy prices are also projected to decline. The July outlook has inflation starting to come back down later this year, easing to about 3% by the end of next year and returning to the 2% target by the end of 2024.

The release concludes by stating that the Bank will "continue to take action as required to achieve the 2 percent inflation target". That obviously points to more rate hikes ahead, but the Bank is hoping that today's dramatic move will limit the scale of future tightening needed to reach its goal. Given the near-term outlook for CPI to remain sticky above 8 percent, that hope will soon be put to the test. 

Go figure

A few years ago, almost every blog post I wrote about Canadian unemployment data contained a little rant about the bizarre volatility of the figures, especially as they related to self-employment. Haven't had to do that lately, but today's employment data for June offer an fresh opportunity.

According to Statistics Canada, employment in Canada fell by 43,000 in June, its first decline since January. That compares to a consensus expectation for a 20,000 increase. However -- and there are a lot of howevers in this report -- the unemployment rate slipped two ticks to a fresh all-time low of 4.9 percent, as fewer people were supposedly seeking jobs during the survey period. That seems improbable; with widely-reported shortages of workers across the country, it is hard to imagine that the so-called discouraged worker effect is at play here. 

So who lost their job in June? It depends on how you slice it. Here is StatsCan's version:

The number of self-employed workers fell by 59,000 (-2.2%), while the number of employees held steady in both the public and the private sectors.

Employment was down among workers aged 55 and over (-51,000; -1.2%). It was little changed among youth aged 15 to 24 and the core-age population aged 25 to 54.

Employment in the services-producing sector declined by 76,000 (-0.5%) in June, with losses spread across several industries, including retail trade.

So at the risk of sounding slightly facetious, the typical job-loser was an older self-employed worker in the service sector.  It's hard to visualize who those employees might be, let alone to imagine that so may of them lost their jobs in a single month. Back to the StatsCan release for a partial explanation:

....every month some self-employed workers find work as employees. In the context of high job vacancies and accelerating wage growth, 5.0% of people who were self-employed in May became employees in June.

Of course, that bit about "high job vacancies and accelerating wage growth" makes the fall in the number of jobseekers all the more mysterious. 

Looking beyond the strange headline numbers, many of the details of the report indicate continued strength in the labour market. Total hours worked rose 1.3 percent in the month; involuntary part-time work continued to fall; and long-term unemployment finally fell back to pre-pandemic levels. As for hourly wage growth, it accelerated sharply to 5.2 percent year-on-year in June, up from 3.9 percent in May. Oddly enough, wages for unionized workers are rising more slowly than for the non-unionized.

The rise in wages remains well below the reported rate of consumer price inflation. Even so, the acceleration in wage gains in recent months will compel the Bank of Canada to stay alert for any signs of an incipient wage-price spiral. Despite the unexpectedly bad headline number, today's data will do nothing to deter the Bank from raising rates again next week, with the consensus now firmly focused on a 75 basis point hike. 

Canada's trade boom

Canada's external trade sector is volatile and hard to predict.  Something like 80 percent of exports go to the Unites States, despite decades of governmental efforts to diversify; hence the well-worn adage, "when the US sneezes, Canada catches pneumonia". And commodities, led by oil and gas, are a large part of the export mix, making Canada's trade performance heavily dependent on global developments over which the country has little influence.  But when things go well...

Statistics Canada reported today that Canada's merchandise trade surplus rose to C$ 5.3 billion in May, the largest for any single month since August 2008. Exports rose 4.1 percent in the month in nominal terms, the fifth consecutive increase; in volume (real) terms, exports rose a more modest 1.7 percent. Meanwhile, imports fell 0.7 percent in nominal terms and 1.4 percent in volume terms. 

The role of international price movements in the burgeoning trade surplus is easy to see. The value of exports is up 20 percent since the start of 2022, but in volume terms, exports are actually 2.3 percent lower. The biggest single contributor is energy: in May, energy accounted for 29.8 percent of Canada's total export earnings, the highest proportion ever. Much of the increase in this category represents sales to the United States; Canada's surplus in bilateral trade reached C$ 14.0 billion in May, the highest on record.

Will these good times last?  Disruption in energy markets caused by sanctions on Russia seems certain to persist for some time, which will support the underlying demand for Canadian energy. However, there are clear signs that the run-up in energy prices has peaked, which will limit the positive price impact on Canada's energy exports even if volumes hold up. To the extent that the pullback in energy prices reflects the possible onset of a global recession, other categories of exports may also start to be affected. Current outsized trade surpluses are thus unlikely to persist for much longer, but amid growing concerns over recession and stagflation, the export sector is for now a bright spot in Canada's economic picture. 

Not exactly what we wanted to hear

The Bank of Canada released its quarterly Survey of Consumer Expectations today. There's plenty in it for the Bank's policymakers to contemplate as they prepare for their next rate decision, due on July 13.

Even as the Bank has embarked on its tightening cycle, it has repeatedly admitted that there is little that it  can directly do to calm the current inflation spike, given that said spike is largely the result of global supply chain issues. The principal goal of its policy moves has been to curb any run-up in inflation expectations, so as to ensure that higher inflation does not become entrenched in the economy even after supply issues ease.

Data in the survey suggest that inflation expectations are indeed rising significantly, for both the short, medium and long term. Expectations for inflation one year out are close to 7 percent, up from just over 2 percent at the start of 2021. (As a reminder, headline CPI was up 7.7 percent in May).  For the two-year horizon, the expectation is just over 5 percent, and for five years it is still well above the Bank's target, at 4.0 percent.

That's not good news, but other elements of the survey are a little more comforting. The survey shows that more than 40 percent of Canadians correctly see supply chain issues as the key driver of inflation. That compares to around 20 percent each for the main alternative explanations: the pandemic and high government spending.  As an aside, this last point suggests that Tory leadership hopeful Pierre Poilievre's  incessant carping about "Justinflation" is not really hitting the mark; not that he's likely to stop. 

The survey also shows that about 80 percent of Canadians think the Bank of Canada can achieve its inflation target either "most of the time" or "some of the time".  Fewer than 12 percent think it can "never" hit the target. Interestingly, almost 8 percent of Canadians responded "never" to this question back in 2019, a time when the country had enjoyed many years of inflation at or below the target level.

The survey tells us there is work for the Bank to do. Inflation expectations of 4 percent over a 5-year time horizon are not something policymakers can feel comfortable about. Markets seem convinced that next week will bring a 75 basis point rate hike. That's very aggressive by recent historical standards, but you wouldn't bet against it.