Recession imminent.....or is it?

The Canadian media have been trying to talk the economy into recession since at least the second quarter of last year, pouncing on the least sign of weakness while ignoring evidence of continuing strength, particularly in the jobs market. At first blush, real GDP data for Q4/2022, released today by Statistics Canada,  seem to hint that a recession might indeed set in early in 2023, but the details of the reports suggest that the economy has some life in it yet. 

Real GDP was essentially flat in Q4, ending a run of five quarters of positive growth. The key areas of weakness were business investment (for a second straight quarter), housing investment (for a third straight quarter) and business inventory accumulation. The weakness in the first two items in that list is at least prima facie evidence that the interest rate hikes implemented by the Bank of Canada since early in 2022 are having an impact on the real economy. 

That being said, however, some other important components of GDP appear to have remained robust through the end of the calendar year. Most notably household spending, which had edged lower in the prior quarter, jumped 0.5 percent in real terms in Q4. StatsCan identifies particular strength in purchases of durable goods including motor vehicles, a category that might be expected to soften if higher interest rates were really starting to bite.

Alongside the quarterly data, StatsCan also released monthly GDP data for December, which are calculated on a somewhat different basis from the quarterly figures. The data show that real GDP edged down 0.1 percent in the month, but the details show that the weakness was not widespread. Twelve of the twenty industrial sectors tabulated by StatsCan posted positive growth in the month, with the only significant weakness showing up in mining, quarrying and oil and gas extraction. This weakness was at least partly seasonal in nature.  

The fall in GDP in December creates a weak "handoff" into the current quarter, which might be seen as increasing the odds of a recession starting right about now. However, StatsCan's preliminary estimate shows a robust 0.3 percent rebound in real GDP in January, largely as a result of a reversal of the seasonal weaknesses that depressed GDP in December. This means that even if monthly GDP is flat in February and March, Q1 as a whole should still be in marginally positive territory.

Those in the media and elsewhere expressing confidence that the Canadian economy will be in recession through the first half of 2023 need to pause for a rethink. The very strong employment data seen in recent reports do not support the idea that the economy is about to fall off a cliff. Although employment is usually characterized as a lagging indicator, it is hard to believe that private sector employers have been adding jobs even as the real economy weakens all around them.  It might also be noted that, at least in the Toronto region, there are signs of an uptick in the housing market as fears over further Bank of Canada rate hikes start to wane. 

The perception that today's data are "weak" will make it easy for the Bank of Canada to justify keeping rates on hold in the near term. There is certainly some evidence in the data that higher rates are having an impact on the real economy. But are those same higher rates also responsible for the decline in inflation that is now well under way? That's a much harder argument to make. 

All about that base effect

Canada's headline CPI rose 0.5 percent (not seasonally adjusted) in January, after declining 0.6 percent in December. Despite the sharp month-to-month reversal, the decline in year-on-year CPI growth continued, with the headline index rising 5.9 percent in January from a year earlier, down from the 6.3 percent increase posted in December. This reflects a very strong "base effect" on the year-on-year calculation, as the outsized monthly increases posted in early 2022 start to fall out of the calculation. The data release from StatsCan actually includes a technical note on the base effect, something that might usefully have been provided sooner.  

Behind the headline number, there are still some concerning elements to today's report. Food prices continue to rise at a double-digit pace, with a 1.7 percent rise in January alone bringing the year-on-year increase to 10.4 percent. Gasoline prices, which have been generally well-behaved in recent months, jumped 4.7 percent in January, mainly as a result of refinery disruptions in the United States.  While overall shelter costs were largely flat in January, the mortgage interest cost index jumped to 21.2 percent year-on-year, the fastest rise in almost forty years. This is, of course, a direct result of the Bank of Canada's inflation-fighting interest rate hikes. 

Measures of core inflation continue to move lower in line with the headline figure. CPI excluding food and energy rose 4.9 percent year-on-year, while CPI excluding mortgage interest rose 5.4 percent. Two of the Bank of Canada's three preferred measures of core inflation eased in the month, but their mean value of just below 5.4 percent is still well above the 2 percent target.

Looking ahead at the February data, it is already evident that the run-up in gasoline prices has fully reversed, which will bias the headline number lower. On the other hand, food price gains are likely to remain robust, not least because one of the largest grocery store chains just ended its voluntary freeze on the prices of own-brand products.  That being said, for February and the next several months, the key to predicting the path of headline CPI will be the base effect. Barring some entirely unforecastable event, the steady removal of last year's bloated figures from the calculation will push the year-on-year number significantly lower until at least mid-year, allowing the Bank of Canada to remain safely on the sidelines.  

US CPI for January: plenty to unpick

The BLS reported today that US headline CPI rose 0.5 percent in January,  the highest month-on-month increase since October 2022.   This was in line with expectations, but because of seasonal adjustment changes -- we'll get to those -- the year-on-year rate came in a little higher than expected, at 6.4 percent. That is still the lowest year-on-year increase since October 2021, so the TL:DR read on the report is that the gradual downward trend in inflation remains in place. 

Some of the sub-components of the index are still running at an eye-watering pace. The "Food at home" (aka groceries) index rose 11.3 percent year-on-year, with many media reports choosing to focus on individual items such as eggs (up 70 percent) and butter (up more than 20 percent). The BLS drew particular attention to the shelter index, which rose 7.9 percent from a year ago and was by far the largest contributor to the rise in the headline figure. It need hardly be said that rising interest rates will make it difficult to move this component lower any time soon. 

Indexes of core inflation remain below the headline figure, while continuing to exhibit the same gradual downward trend. CPI ex food and energy rose 0.4 percent in the month, bringing the year-on-year increase to 5.6 percent, the lowest figure recorded since December 2021. The increase in the shelter index accounts for almost 60 percent of the rise in  core CPI over the past year.

Now, what about those seasonal adjustment factors? The BLS adjusts these regularly, and today's report included the latest changes. The initially-reported monthly increases for each month of Q4/2022 were reported marginally higher; this explains why the analysts' consensus for a 6.2 percent rise in the headline figure turned out to be too low, even though the consensus for the monthly change was spot-on

Here's the thing about seasonal adjustments, though. If you do them properly -- and I think we can assume the BLS does that -- then over the course of the year they're a wash. Months in which the seasonally adjusted data are higher than the raw numbers are offset by months where the adjusted numbers are lower. The implication of this is that since the seasonal adjustment has now boosted the October-December numbers, there should be some months coming up where the adjustment biases the monthly numbers downward. This should help ensure the downward drift in inflation continues at least until mid-year.

The Fed's job may not be done yet, but there is nothing in today's slightly higher print to suggest that much more monetary tightening is needed. 

The jobs keep coming

A week on from the startlingly robust US non-farm payrolls report for January, we learn that Canada's job market performed even more strongly in the same month. Statistics Canada reported this morning that the economy added 150,000 jobs in the month which,  given the relative size of the two economies, would be equivalent to a print close to 1.5 million for the US. The unemployment rate was unchanged at a near-record low of 5.0 percent as the labour force participation rate moved higher. 

The details of the report are uniformly strong. The bulk of the gains -- 115,000 jobs -- occurred in the private sector, and 121,000 of the jobs added in the month were full-time in nature. The gains were spread across a wide range of industries and well-distributed geographically, with only Newfoundland and Labrador posting a very small decline in employment. One possible caveat that might be worth keeping in mind is that there could be a seasonal adjustment issue here. Ontario and Quebec both posted very strong job gains, and both Provinces have had a less harsh winter than usual, which may have given some modest boost to employment in January. 

Given that the economy has now added 200,000 jobs in the space of two months, the trend in wage growth is perhaps the most surprising aspect of today's report. Year-on-year wage gains slowed markedly for a second consecutive month, to stand at 4.5 percent in January; this may be compared to the apparent cyclical peak of 5.8 percent recorded in November 2022.  

It was obvious that the FOMC knew about the non-farms data when it made its latest rate decision. Given the timing of StatsCan's survey, it is all but impossible that the Bank had any inkling of today's numbers before it announced its rate decision in late January.  Would it have made any difference? It very well might. Should it make any difference? That's a different question. A scenario in which employment is rising sharply while inflation falls and wage gains slow is entirely inconsistent with the Phillips curve framework that seems to underlie the Bank's policy stance. As I have suggested here before, it may be time for a rethink. 

So, this is new

For the first time ever, the Bank of Canada has released a summary of the deliberations at its Governing Council meeting. This readout relates to the meeting on January 25, at which the Bank raised its target  rate by 25 basis points and announced a "conditional pause" in its policy tightening. The summary reads like a much-expanded version of the press release issued on the day of the meeting, but does serve to underline the fact that the decisions that were announced were by no means a foregone conclusion. We also now have a better idea of what it might take to convince the Bank that the pause was a mistake. 

Here are a few key quotes, with commentary:

• Members agreed that momentum in inflation is turning a corner, with three-month annualized rates of inflation below the year-over-year rates for both total CPI inflation and, to a lesser extent, core measures of inflation. Hallelujah!  This is just about the first time that the Bank has focused its (and our) attention on the behaviour of inflation in recent months, rather than continuing to obsess over the very dated year-on-year number. It would be helpful if this remains the Bank's way of presenting the inflation data in the months ahead; the "base effect" will take some time to work itself out, meaning that the year-on-year rate will remain misleading until about mid-year. 
• The past few months of data ....made it clear that the tightness in the labour market persisted..... Overall, Council concluded that wage momentum was plateauing in the range of 4% to 5%. Persistent wage growth in this range was not viewed as consistent with achieving the 2% inflation target unless productivity increases to well above its historical trend. There are plenty of points that can be made here. The fact that wage gains are plateauing even as labour market conditions remain tight seems like a convincing refutation of the Phillips curve approach that the Bank (and its counterparts around the world) have been allowing to drive their policy approach.  As for the productivity outlook, it is at least arguable that historic trends may not provide much guidance in the unprecedented times we currently face. However, given Canada's abysmal productivity record, the Bank's caution is perhaps warranted. 
• Finally, while several factors were combining to bring overall inflation down, Council discussed the risk of it becoming stuck materially above the 2% target. Persistence in supply chain challenges, services price inflation, wage growth and inflation expectations could all keep inflation above the target. A rebound in oil prices could also push inflation back up again. This passage sums up the risk factors that could persuade the Bank to end its "conditional pause' and resume its tightening course. The Bank's base case sees inflation falling to 3 percent by mid-2023 and to the 2 percent target by 2024, but the listed factors are the most obvious threats to this favourable outcome. 

Release of these summaries will presumably become a regular feature of the Bank's communications strategy going forward. That can only be a good thing.  

D'you think he knew?

Of course he did! Central bankers never want to be embarrassed by data releases just after they announce policy decisions, so there is no doubt that Fed Chair Jay Powell and his FOMC colleagues were granted a sneak peek at the December non-farm payrolls data ahead of their meeting earlier in the week. The extraordinary content of this morning's data release from the BLS clearly shows why Powell took such a cautious stance on the future direction of Fed policy. 

The US economy added a stunning, remarkable, (your adjective here) 517,000 jobs in January, way more than twice the consensus expectation. What's more, the previously-reported data for November and December were revised upward by a total of 71,000 jobs. The unemployment rate remains at a historically low 3.4 percent. 

The details of the release have already been exhaustively parsed in the media. Here, for example, is a lengthy and breathless exegesis by CNN, excited beyond belief by having to cover both this news and the bizarre Chinese balloon story on the same day. Just a couple of points to stress, in case they haven't already been covered elsewhere. 

• Employers have been wringing their hands over the near-impossibility of finding the workers they need for many months now, and yet today we find that the economy has somehow managed to add around a million new positions in just the least three months. Where are all these people coming from?  There are some clues in today's report. The BLS notes that the participation rate remains stubbornly below its pre-pandemic level. Moreover, it appears there are still over 4 million workers in part-time jobs who would rather be working full time. These little snippets of data suggest that the overall job market is not quite as tight as the headline figures make it look.
• Wages gains remain well-controlled. The year-on-year rise in average hourly earnings stood at 4.4 percent, below the year-on-year rise in consumer prices. Moreover, the month-on-month gain in wages in January was just 0.3 percent, which may imply that wage gains are actually moderating slightly. 

Today's numbers leave little room for doubt that the Fed will be raising rates again at the next FOMC meeting on March 21-22 -- unless, of course, there is a nasty negative surprise in the February payrolls data, which will be out on March 3. That said, the continuing absence of any real upward pressure on labor costs still suggests that the tightening cycle does not have much further to go.

Not even a hint

Sure, today's 25 basis point rate hike by the Federal Reserve was its smallest move in almost a year. But to understand the Fed's mindset, you just need to read the last sentence of each of the first three paragraphs of today's media release: 

..... Inflation has eased somewhat but remains elevated.

..... The Committee is highly attentive to inflation risks.

..... The Committee is strongly committed to returning inflation to its 2 percent objective.

Clear enough for ya? No sign of a "pivot" there. Indeed, the release repeats the now-familiar message that The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. This is followed by a boilerplate acknowledgement 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. Even so, markets can be in little doubt that the Fed does not believe its job is done just yet. 

Fed Chair Powell's imminent press conference may paint a somewhat more nuanced picture. Even so, it is striking to observe the contrast between the Fed's tone and that adopted by the Bank of Canada when it announced its "conditional pause" in tightening in January. The last "dot plot" of FOMC members' predictions showed that most expected the funds target to reach and likely top 5 percent. With the target now at 4.50-4.75 percent, and given the tone of today's statement, that seems likely to happen before any pivot takes place.