And still it grows

The Canadian media have been crying recession ever since the Bank of Canada started raising rates at the start of the year. So far, the actual economy is refusing to play along. Statistics Canada reported today that real GDP rose 0.1 percent in July, reversing its preliminary forecast of a 0.1 percent decline. Preliminary data for August call for a flat outcome. 

In truth, there is not a whole lot to like about the July data, though it is remarkable to see the Canadian economy still performing significantly stronger than the US. Growth in July was led by the goods-producing sectors, which showed a 0.5 percent gain. This was the result of particular strength in resource extraction (up 1.9 percent) and agriculture (up 3.2 percent).  This was partly offset by a 0.5 percent fall in manufacturing output, led by durable goods, marking the third decline in this sector in the last four months. 

The services sector posted a 0.1 percent decline in the month. Both wholesale and retail trade declined, as did the restaurant sector.  Real estate agents and brokers saw a fifth straight month of falling activity, evidently a reflection of the tighter policy settings at the Bank of Canada. However, activity in the public sector posted a 0.4 percent monthly gain. In all, just eleven of the twenty sub-sectors tracked by StatsCan posted higher output in the month. 

In sum, the Canadian economy is clearly on a significantly slower growth path, but is nowhere close to any reasonable definition of recession, however galling that fact may be to the headline writers. That being said, the economic background against which the Bank of Canada makes its policy decisions has clearly shifted. Slower growth, evidence that the domestic inflation cycle has peaked and growing skittishness in global financial markets all point to the need for much less aggressive policy actions in the months ahead. 

Down the khazi with Kwasi?

Back in 1972, the UK's Conservative Government was in trouble, amid economic stagnation and worker unrest, and with a general election due in less than two years. I was living there at the time, a recent graduate employed at the Foreign Office in Whitehall.  Chancellor of the Exchequer Tony Barber tabled a highly irresponsible budget designed purely to put the Tories in a position to win the next election. 

The Tory media were predictably laudatory. One of the tabloids, possibly the Daily Mail, ran a front page with a cartoon of a jet with Barber's face, with the headline "Take off with Tony". The rest of the page described the budget in large print as "the roaring, soaring giveaway that knocks all others flat".  It produced a short-lived "Barber boom", but soon set the UK onto a boom-and-bust trajectory that persisted for better than a decade. And despite it all, Labour came to power in 1974. 

The UK media are comparing today's mini-budget tabled by rookie Chancellor Kwasi Kwarteng to Barber's disastrous experiment, and not without reason. PM "Thick Lizzie" Truss had already announced a wildly expensive plan to protect consumers and industries against rising fuel prices, eschewing the logical option of a windfall tax on energy company profits and opting instead to ramp up borrowing. Kwarteng's package of tax cuts and other measures, almost exclusively to the benefit of the most well-off, will further boost the UK's borrowing requirements, all while adding to inflationary pressures. 

Small wonder, then, that Sterling has tumbled below US$1.10 and Gilt yields have soared. No less an eminence than Larry Summers has opined that "Britain will be remembered for having pursued the worst macroeconomic policies of any major country in a long time".  Even the reliably pro-Tory Daily Mail is aghast, reminding its readership of the disaster that followed Barber's budget, though not reminding those readers that at the time, it thought Barber's budget was a damned fine thing.  

Truss has a solid majority, so the chances of  the Tories being ejected from office early are slim. Based on her first three weeks in office, she looks capable of doing a whole lot of damage. 

Fed sticks to its task

In line with market expectations, the Federal Reserve today imposed its third straight 75 basis point increase in the funds target range, which now stands at 3.0 - 3.25 percent. The press release signals there are more rate hikes to come, and also commits the Fed to continuing its policy of quantitative tightening. 

As was the case after the last rate hike, the press release's discussion of the economic background to its decision is skimpy. It almost seems that the Fed is saying to markets, "if you don't understand what we're doing by now, you are never going to understand".  Apart from a short paragraph on the impact of Russia's depredations in Ukraine, this is the entire text on the economy:

Recent indicators point to modest growth in spending and production. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.

Nothing very controversial there. What is striking is that the release offers no hints that the Fed yet sees any indications that its tightening policies are having the desired effect on either the real economy or inflation. Nor is there any mention of inflation expectations, even though keeping these in check is surely the main goal of this series of sharp rate hikes -- after all, there is not much that monetary can realistically do about the underlying causes of the recent inflation spike. 

There seems to be at least some risk that the Fed is too busy looking in the rearview mirror to see that there may be a turn coming. It is true that headline CPI is still way above target on a year-on-year basis, but that will inevitably remain true for some months to come because so many of the high monthly prints from late last year and early this year are baked into the calculation. The last two monthly prints have been much lower, possibly signalling a change in the underlying trend. 

That being said, there are still reasons for the Fed to be cautious. First, the recent lower CPI data have been heavily influenced by one factor -- gasoline prices -- and signs of a slowdown in wider inflation pressures remain elusive.  Second, until there is clear evidence of a decline in inflation expectations, the Fed will feel it cannot afford to take its foot off the brake. 

So how much further do rates have to rise? A glance at the chart deck released today tells us that the median expectation of the FOMC members for the funds rate in 2023 is now 4.6 percent, up a startling 80 basis points from the June projection. Even for 2024, the median projection is barely below 4 percent. Evidently the FOMC believes that it will take a prolonged period of high rates to get inflation back to the target. It's getting harder to believe that this scenario is compatible with anything like a soft landing for the real economy. 

Slowly but surely

Canadian CPI data for August, released by Statistics Canada this morning, suggest that we may now be past the worst of the recent inflation spike. On a year-on-year basis headline CPI slowed more than expected, falling to 7.0 percent from the 7.6 percent  recorded in July and 8.1 percent in June, which now seems likely to have been the peak. Monthly numbers, which are arguably more relevant* than the yearly numbers at turning points, provide even stronger evidence of the emerging trend: unadjusted CPI fell 0.3 percent in the month, the biggest decline since early in the COVID pandemic, while the seasonally adjusted headline number rose 0.1 percent, the smallest rise since December 2020. 

As was the case in July, falling gasoline prices accounted for much of the improvement in headline inflation. Gasoline prices once again fell by more than 9 percent month-on-month, though they remain more than 22 percent higher than a year ago. Even stripping out gasoline prices, the August data show some sign of a changing trend: the year-on-year increase for CPI excluding gasoline slowed to 6.3 percent from 6.6 percent a month earlier, the first deceleration in this measure since June 2021. 

The most concerning aspect of the latest data continues to be the performance of food prices. Grocery prices rose 10.8 percent from a year earlier, the fastest pace seen since 1981, and StatsCan characterizes the increase as "broad-based". Excluding both food and energy, the increase in CPI was 5.3 percent, down from 5.5 percent in July. 

The Bank of Canada's preferred core measure of inflation, which have been rising inexorably for many months, finally went into reverse in August. The mean value of these three measures slipped by about 0.2 percent in the month, to just over 5.2 percent.

The clear evidence of a turning point in CPI growth will obviously factor in to the Bank of Canada's rate decision in October. It is unlikely that we will see any more outsize rate hikes in this cycle; a 25 basis point move is altogether possible.  The likelihood that the Bank may now be on a less aggressive tightening track than the Federal Reserve is contributing to the moderate weakening in the Canadian dollar, which could add to Canadian inflation in the medium term. However, amid signs that rate hikes are having a growing impact on the domestic economy, particularly the housing sector, the Bank is unlikely to react strongly to the falling exchange rate. 

* This is a point that the media seem determined to overlook. The year-on-year CPI increase is composed of twelve separate monthly data points. The older numbers, which were considerably larger than those we are now seeing,  only fall out of the index one at a time. Focusing on the year-on-year data as a guide to Bank of Canada policy is like driving while looking in the rear view mirror. We can hope that the Bank knows better. 

What's going on?

Canadian employment data continue to be both worrying and hard to parse. Statistics Canada reported today that employment fell by 40,000 in August, its third consecutive decline.  Employment has fallen by a total of 114,000 since May. This month's decline served to push the unemployment rate up by half a percentage point, to 5,4 percent. 

The fall in employment was concentrated in two sectors: education lost 50,000 jobs in August, while employment in construction was down 28,000. These losses were only partly offset by gains in parts of the services sector.  The job losses in education may well be largely seasonal in nature and may be reversed in September.  However, the significant decline in construction employment may be an early indication that the Bank of Canada's rate hikes are starting to have an effect. If the Bank indeed had an sneak peek at these numbers before Wednesday's rate announcement, its decision to proceed with a further 75 basis point rate hike looks questionable. 

There is one element of the data that will raise concerns at the Bank. Average hourly wages rose 5.4 percent in the year to August, up from 5.2 percent in each of the two preceding months. This is still far short of the rise in consumer prices, most recently reported at 7.6 percent, but it shows that any incipient weakness in the jobs market has not yet had any dampening effect on wages.

The employment data are hard to square with the available data on the real economy, with real GDP growing in both Q1 and Q2 and falling only marginally in July.  In addition, anecdotal data continue to suggest that employers are having trouble finding the staff they need -- our local Tim Hortons was closed once again yesterday evening!  Still, three months of weakness in employment cannot be ignored by policymakers if their goal is to produce a soft landing rather than a recession. It seems quite certain that we are much closer to the end of the tightening cycle than the beginning. 

Beyond neutral

In line with market expectations (though not this blogger's; mea culpa), the Bank of Canada raised official interest rates by 75 basis points today. The overnight rate target is now 3.25 percent, just above the 2.5-3.0 percent rate the Bank (and markets) consider to be "neutral".  The generally hawkish tone of the press release suggests there are more hikes to come.  

That press release notes that the domestic economy remains strong, though there are signs that things may slow down in the second half of this year as the impact of policy tightening starts to be felt:

The Canadian economy continues to operate in excess demand and labour markets remain tight. Canada’s GDP grew by 3.3% in the second quarter. While this was somewhat weaker than the Bank had projected, indicators of domestic demand were very strong – consumption grew by about 9½% and business investment was up by close to 12%. With higher mortgage rates, the housing market is pulling back as anticipated, following unsustainable growth during the pandemic. The Bank continues to expect the economy to moderate in the second half of this year, as global demand weakens and tighter monetary policy here in Canada begins to bring demand more in line with supply.

As for inflation, the Bank sees little reason for optimism in the near term, and continues to fret about the risk that expectations of persistently high inflation may become entrenched:

CPI inflation eased in July to 7.6% from 8.1% because of a drop in gasoline prices.  However, inflation excluding gasoline increased and data indicate a further broadening of price pressures, particularly in services. The Bank’s core measures of inflation continued to move up, ranging from 5% to 5.5% in July. Surveys suggest that short-term inflation expectations remain high. The longer this continues, the greater the risk that elevated inflation becomes entrenched.

One development that may be causing heightened concern for the Bank is the way Canadian households are dealing with the rising cost of living. Surprise, surprise, they are borrowing more. A new report from TransUnion Canada shows that consumer debt in Q2 stood 9.2 percent higher than a year earlier and 16 percent higher than before the pandemic.  Although delinquency rates remain low, this must be expected to change as higher rate begin to bite. Forget the political squabbling over the state of public finances: it is the financial health of the household sector that currently poses the greater threat to Canada's financial stability, given debt levels and the abrupt correction in the housing market. 

At the conclusion of the press release, the Bank's Governing Council still judges that the policy interest rate will need to rise further. However, it is reasonable to surmise that the phase of outsize rate hikes is at an end. After a disastrously late start, the Bank has now raised rates by 300 basis points in little more than half a year. A reversion to more customary 25 basis point increments is now in the cards, and if the bite on household finances continues to worsen, we may soon be at the end of this tightening cycle.