Data points

A couple of data releases so far this week with implications for monetary policy on both sides of the 49th parallel....

In the US, the Bureau of Labor Statistics released the employment cost index (ECI) for the December quarter.  This index was once Fed Chairman Greenspan's favourite, at least until it stopped behaving the way he wanted it to. It is generally regarded as a better indicator of overall labour costs than the wage data in the non-farm payrolls reports. 

The BLS data show that overall labour costs rose 1.0 percent in the final three months of December. That's below market expectations, and considerably lower than the 1.3 percent gain posted in the September quarter.  The year-on-year rise in the ECI eased to 5.0 percent in December from 5.1 percent in September. These numbers are well below the headline rate of CPI inflation and show little evidence that the much-feared wage-price spiral is about to materialize. 

That being said, the latest quarter-on-quarter ECI print annualizes to just over 4 percent, slightly above the annualized increase in core CPI for the same three months, which stands at 3.2 percent. This is likely to make the FOMC cautious about declaring victory when it releases its rate decision on Wednesday. A 25 basis point rate hike is the likeliest outcome, and the Fed is likely to be less explicit than the Bank of Canada in signalling a pause in the tightening cycle. 

In Canada, today saw the release of GDP data for November, with the economy eking out a 0.1 percent gain for the month. Service-producing sectors posted a 0.2 percent gain, partly offset by a 0.1 percent decline in goods-producing sectors. Much of the gain in services occurred in the public sector, so the report appears to show that Bank of Canada policy tightening is now starting to weigh on private sector activity. Preliminary estimates suggest that real GDP growth was flat in the month of December.

The data appear to vindicate the Bank of Canada's decision this month to announce a "conditional" pause in its tightening cycle. The Bank expects GDP growth to stagnate for the first half of this year, which right now looks like a reasonable-to-slightly-optimistic forecast. Whether the soft landing turns into a technical recession remains to be seen. 

Canada fiscal update

This never seems to get much media attention, but Canada's fiscal situation, at least at the federal level, continues to evolve favourably. The latest Fiscal Monitor, published by the Department of Finance this week, shows that the cumulative deficit for the first eight months of fiscal 2022/23 (i.e. April-November) stood at C$ 3.6 billion. That compares to a deficit of C$ 73.7 billion for the same period of fiscal 2021/22.  The remarkable improvement is fairly evenly split between higher revenues and lower program spending. 

In the Fall financial statement just a couple of months ago, Finance Minister Chrystia Freeland projected a deficit for the full year of C$ 36.4 billion, a number which seemed improbably high even at the time. At first blush, the latest data suggest that the actual outcome will be very much lower than that projection. That will probably turn out to be the case, but it is likely that the monthly data for the rest of the fiscal year will not be as good as those seen so far. 

It is noteworthy that revenues for the month of November were slightly down on the previous year's level.  This reflects the impact of some of the measures announced in the Fall statement, notably a temporary doubling of the GST credit, and a similar impact on revenues is likely to be evident in the remaining months of the fiscal year, especially with the economy growing more slowly.  Spending is always higher in the latter part of the fiscal year, and there is no reason to expect anything different to happen this year.  

Lastly, the Government always uses a "thirteenth month" to allow for unforeseen factors (and outright window-dressing) at the end of the fiscal year. With the prospect of an unusually large gap between budget estimates and the actual outcome, the adjustment for the thirteenth month is likely to be even larger than usual this year. Still, the final budget deficit looks set to be much lower than expected -- which, this being a Liberal government, will likely set the stage for further spending announcements come budget day.  

A pause for the cause

In line with market expectations, the Bank of Canada today raised its overnight rate target by 25 basis points, bringing it to 4.5 percent. More significantly, in his subsequent press briefing Governor Tiff Macklem explicitly announced a pause in tightening: "With today’s modest increase, we expect to pause rate hikes while we assess the impacts of the substantial monetary policy tightening already undertaken". 

The media release is much more detailed than usual in its analysis of the economic situation, and further details can be found in the updated Monetary Policy Report. The Bank notes that the economy has grown slightly faster than expected in recent months, but it sees signs that past monetary policy moves are now working to slow activity, especially household spending: "Consumption growth has moderated from the first half of 2022 and housing market activity has declined substantially. As the effects of interest rate increases continue to work through the economy, spending on consumer services and business investment are expected to slow".  This is likely true, but whether slowing demand is the main reason inflation is declining rapidly is it is of course a quite different question, and one that may cast doubt on whether the Bank's policy actions have had much impact at all on inflation.

The Bank's latest forecast sees GDP growth stalling in the first half of this year but picking up later, to give real GDP growth for the full year of just 1 percent, down from an estimated 3.6 percent in 2022. It expects headline CPI, most recently standing at 6.3 percent year-on-year, to fall to 3 percent by mid-year and to return to the 2 percent target by 2024. Barring new geopolitical shocks, it is possible to construct scenarios in which the 2 percent target is reached some time this year, but whether the actual outcome is 2 percent or 3 percent, the decline will owe much more to "base effects", as last year's bloated monthly numbers fall out of the index, than to anything the Bank has done. 

Macklem tempered his promise of a pause with a warning:  "To be clear, this is a conditional pause—it is conditional on economic developments evolving broadly in line with our MPR outlook. If we need to do more to get inflation to the 2% target, we will". Fair enough, but it seems more than likely that the Bank has reached the end of this tightening cycle, and having official rates back in more historically normal territory can only be a welcome development. There are already a few commentators predicting that rates will start falling again in the second half of this year. You wouldn't rule it out. 

Canada CPI -- more good news, but is it enough?

Statistics Canada reported this morning that the year-on-year rise in headline consumer prices slowed to 6.3 percent in December from 6.8 percent in November. On an unadjusted basis, headline CPI fell 0.6 percent month-to-month, the largest decline since the peak of the first wave of the COVID pandemic in April 2020.

The details of the report paint a somewhat more nuanced picture than the headline, but there can no longer be any doubt that Canada's inflation trend, like that in the US, has turned lower. The biggest contributor to the lower headline number rate was a 13.1 percent fall in gasoline prices, which now stand only 3 percent higher than they did before the Russian invasion of Ukraine. In contrast the headline number for food prices looks less encouraging at first blush. The year-on-year figure that the media like to focus on is 10.1 percent (and an even higher 11 percent for groceries), but the month-on-month increase is a much more encouraging 0.3 percent, which annualizes to less than 4 percent.

Core CPI, defined to exclude food and energy costs, fell 0.1 percent in December, for a year-on-year increase of 5.3 percent, just a tick lower than the November reading.  It might be noted that fastest-rising component of core CPI is now shelter costs, which stand 7 percent higher than a year ago. A large component of this is of course rising mortgage costs, which are being pushed up by the aggressive Bank of Canada rate hikes that are supposed to help bring inflation down.

The Bank of Canada's three preferred measures of core inflation all turned slightly lower in the month -- welcome news, although it is not clear that the Bank pays much attention to these any more. The interest rate decision due on January 25 will depend on whether the Bank is convinced that the tame monthly data seen in recent months really mark a sustainable change in the underlying trend. With the headline and core figures still above the target range, a further small rate hike to underscore the Bank's resolve seems the likeliest outcome, so look for a 25 basis point move, coupled with hints of a possible pause.  

The slippery slope

There's no denying that the taxpayer-funded health care system in Ontario, in common with much of the world, is under strain at the moment. The impact of years of under-funding has been greatly exacerbated by the COVID pandemic, resulting in delayed surgeries and even occasional, short-lived closures of emergency rooms in rural areas.  

There's also no denying that Ontario Premier Doug Ford thinks the private sector does just about everything better than the public sector, so it's no surprise that his solution to the health care crisis is to start farming more of it out to the private sector. This morning the Premier announced a three-part plan to do just that, starting with cataract surgeries, then moving on to diagnostic tests such as colonoscopies, and then to knee and hip replacement. This is all controversial, to put it mildly. Here are a few preliminary thoughts. 

The first point that needs to be made is that there is already a lot of private money involved in the Ontario health care system. As the linked article notes, there are already 900 private diagnostic and surgical offices in the Province. Moreover, dental and routine ophthalmic care is basically fully private already, and most people do not get any public funding for prescription drugs. Insurance companies enthusiastically fill the airwaves with ads to help with the cost of services the public system does not cover. 

Premier Ford is adamant that the steps being introduced today will not require Ontarians to reach for their credit card when they visit a private clinic. Your health card (known as an OHIP card) will still have you covered.  He is equally adamant that the new clinics will not in any way cannibalize the public system, particularly as regards staffing.  That can surely only be true if there are squadrons of ophthalmic surgeons (and later, orthopedic surgeons) currently sitting around twiddling their thumbs outside the public system, just waiting for the opportunity to open a clinic of their own. 

It can be fairly confidently stated that that's not the case. Staffing for the new clinics will exacerbate the existing shortage of medical professionals in Ontario. A much better solution already exists for that shortage: speed up the process of certifying fully-qualified immigrants to work in the Province's health-care system. 

Cataract surgery and diagnostic testing is one thing, but joint replacement, even relatively routine procedures like knee and hip replacements, is surely another thing altogether.  How many private sector clinics will invest in the premises and equipment needed to carry out these surgeries quickly and safely? Will they really be able to do this at a lower cost than the public sector does?  Then there is the issue of surgical complications. In the UK, which has a fully-fledged private system alongside the NHS, the private sector only takes on routine operations: anything that looks likely to run the risk of complications is quickly punted back into the public system. As in most areas of "public-private partnership", it quickly becomes apparent that the private sector has much more appetite for reward than it does for risk. 

There may well be a case for small stand-alone clinics to cover routine procedures and take the pressure off full-service hospitals. It's much less clear that the private sector will operate such clinics more efficiently and economically than the public sector can. And the really big fear here has to be that,  having whetted his appetite with the relatively minor steps announced today,  Doug Ford will sooner or later press ahead with much wider privatization of health care.  

Given Ontario's proximity to the United States, this recent warning from the excellent UK blogger Chris Dillow about health care problems in that country's National Health Service surely goes double here: In this world, we must guard against the (high) risk that the task of reforming the NHS will be undertaken by vicious incompetents in hock to US insurance companies. There would be very little support for that in any part of Canada, but that doesn't mean Ford isn't thinking about it. Ontario's healthcare system may just have been placed on a very slippery slope. 

Compelling and consistent enough for ya?

As noted in a previous post, FOMC member Michelle Bowman recently said she was looking for "compelling" and "consistent" evidence that inflation was headed back toward the Fed's 2 percent target before concluding that policy tightening had gone far enough.  Will the December CPI data, released today by the Bureau of Labor Statistics, influence her thinking in any way?  Let's take a look.

Per the BLS, headline CPI fell 0.1 percent in the month of December, the first month-on-month decline since May 2020. This lowered the year-on-year rate to 6.5 percent from the 7.1 percent recorded in November. It's worth pausing for a second to reflect on the fact that a very small month-on-month decline led to a much bigger fall in the year-on-year rate. As noted many times already on this blog, the year-on-year rate, with which the media are obsessed, is very literally old news, biased higher by the alarming monthly data seen almost a year ago.  As the very large month-to-month increases seen in early 2022 start to fall out of the index, the year-on-year rate should move steadily lower in the months ahead.

Unsurprisingly, the continuing fall in energy prices was a major contributor to the December data. Gasoline prices fell 9.4 percent in the month and are now, remarkably, 1.5 percent lower than a year ago. However, the good news was not confined to energy prices.  Prices for food at home rose only 0.2 percent in December, down from 0.5 percent in November, well below the monthly pace seen throughout 2022, although the year-on-year rate remains elevated at 11.8 percent. 

Stripping the always volatile energy and food subcomponents out of the index, there are clear signs that the core inflation rate is easing. The index for all items except food and energy rose 0.3 percent in the month, with the year-on-year rate falling to 5.7 percent from the 6.0 percent pace seen in November. The annualized rate of increase in this index for the last three months (October-December) is 3.2 percent; by comparison the annualized rate for July-September was close to 6 percent. 

These lower inflation numbers no longer look anomalous -- they appear to indicate a real change in trend. Will this be sufficiently compelling and consistent to sway Ms Bowman and her colleagues?  We'll just have to wait until February 1 to find out.  

No sign of a Fed pivot

Two Fed speakers on the docket today: Chair Jerome Powell speaking in Sweden on central bank independence, and Governor Michelle Bowman speaking in Florida on a range of topics, including the outlook for monetary policy. For once, it's the less senior speaker, Ms Bowman, who is the first incumbent of the "community" seat on the Fed's board,  that we need to focus on. 

Ms Bowman is emphatic that the Fed has more work to do to get inflation back to an acceptable level: 

In recent months, we've seen a decline in some measures of inflation but we have a lot more work to do, so I expect the FOMC will continue raising interest rates to tighten monetary policy, as we stated after our December meeting......

I will be looking for compelling signs that inflation has peaked and for more consistent indications that inflation is on a downward path, in determining both the appropriate size of future rate increases and the level at which the federal funds rate is sufficiently restrictive. I expect that once we achieve a sufficiently restrictive federal funds rate, it will need to remain at that level for some time in order to restore price stability, which will in turn help to create conditions that support a sustainably strong labor market. 

At the same time she is optimistic, based on the resilience of the employment market, that the Fed can get inflation lower without causing a "significant" economic slowdown:

.....unemployment has remained low as we have tightened monetary policy and made progress in lowering inflation. I take this as a hopeful sign that we can succeed in lowering inflation without a significant economic downturn. It is likely that as a part of this process, labor markets will soften somewhat before we bring inflation back to our 2 percent goal. While the effects of monetary policy tightening on the job market have generally been limited so far, slowing the economy will likely mean that job creation also slows. And if there are unforeseen shocks to the economy, growth may slow further.

There is nothing especially new here, and certainly nothing whatsoever to suggest that the hoped-for pivot in policy is anywhere close. The part of the Fed's analysis that is becoming harder to grasp with each passing week is this: just what would constitute the "compelling signs" and "consistent indications" that Ms Bowman and her colleagues are looking for to indicate that tightening has gone far enough?  Headline CPI peaked as long ago as the second quarter of 2022, and in recent months the running rate of inflation (as opposed to the highly misleading year-on-year rate) has moved closer to the 2 percent target.   

Chair Powell has occasionally acknowledged that monetary policy operates with significant lags, but Ms Bowman's remarks seem to show that to be rhetoric rather than an indication of future policy moves. The only question regarding the outcome of the next FOMC meeting (January 31 - February 1) seems to be whether the Fed hikes by 25 or 50 basis points. There's a good case to be made for a pause in tightening, but it seems unlikely to get much of a hearing.  

Time for a rethink

Things are not working out the way the Federal Reserve and the Bank of Canada expected. Their rapid policy tightening is aimed at bringing inflation back to the 2 percent target in both countries.  Inflation is coming down all right: in both the US and Canada it is well below the peak seen in mid-2022, with further declines in prospect in the months ahead.  Yet employment on both countries continues to increase smartly, with little sign of any increase in wage growth.  The 60-year-old Phillips curve proposition that unemployment and inflation are inversely related seems not to apply in today's circumstances. Who knew? (Spoiler alert: quite a lot of people did, just not the decision makers at the central banks).

Canada's December employment data, released this morning, are downright startling.  The economy added 104,000 jobs in the month, far surpassing consensus expectations. The unemployment rate ticked down to 5.0 percent, just 0.1 percent above its all-time record low. The details behind the headline figures are uniformly strong: 85,000 of the new jobs were full-time in nature, and all of the newly-created jobs were in the private sector. The services sector accounted for the bulk of the gains, but there was also increased employment in the goods-producing sectors, apart from manufacturing.  Year-on-year wage gains actually eased to 5.1 percent in December from the 5.6 percent pace posted in the previous month. 

The December employment data for the US are not as remarkable as those for Canada, but still show a labour market that is in robust health despite all the Fed's efforts. The economy added 223,000 jobs in December, slightly above market expectations. This pushed the unemployment rate down to 3.5 percent. There were small downward revisions to the data for October and November, but despite these, 2022 was one of the strongest years on record for US employment. Year-on-year wage gains eased to 4.6 percent in the month from 5.1 percent in November. 

It seems depressingly likely that both the Bank of Canada and the Fed will see today's data as cause for further rate hikes later this month. They should instead be asking themselves whether their whole approach is wrong. The whole Phillips curve approach to inflation fighting relies on the idea that wage rises are a key driver of inflation, meaning that increasing unemployment s the way to get inflation under control. This may once have been true -- back in the 1970s and 1980s maybe -- but it is clearly not the case today.  The global inflation spike resulted from supply chain disruptions, created by the COVID pandemic and then exacerbated by the Russian invasion of Ukraine. Wages have not been part of the problem at any stage, as the December data very clearly show. 

CPI Inflation is going to fall in the coming months whether or not the central banks take any further action -- it's pretty much baked in to the data by the so-called "base effect".  Raising rates further is almost pointless and could at some stage be damaging to the real economy.  Messrs Powell and Macklem -- it's time for a rethink!