Maybe this time?

The Canadian media have been talking about -- indeed, talking up -- an imminent recession in Canada since about June of last year, and it hasn't come close to happening. Do the relatively weak GDP numbers released this morning mean the slowdown is about to begin? Let's take a look.

According to StatsCan, real GDP rose just 0.1 percent in February. That's weaker than the agency's own preliminary estimate, but note that the growth rate for January, originally reported at a strong 0.5 percent, has now been revised even higher, to 0.6 percent.  The preliminary estimate for March points to a 0.1 percent decline, but even if that happens, real growth for Q1 as a whole is estimated at an annualized pace of 2.5 percent. If you accept the customary definition of a recession as two consecutive quarters of declining GDP, then it will be many months yet before the media forecasts finally prove true. 

That being said, the relative weakness of the economy in February and March, after the very strong gain posted in January, may set the stage for a weak second quarter. The weak March number means that real GDP at the start of Q2 was marginally below its average level for Q1. Hypothetically, if monthly GDP numbers were flat for each month from April to June, the reading for Q2 as a whole would show a slight decline from Q1. 

Then again, real GDP posted monthly declines in both October and December of 2022, only to bounce back smartly the following month. The rest of the data flow, particularly the sustained strength in the employment market, does not suggest the economy is about to topple into a phase of outright contraction. Pace the media, those recession calls may still have to wait a while. 

There is nothing in today's data to change the outlook for Bank of Canada policy in the near term. The "conditional" pause will remain in place for some time to come, even if the Fed does hike the funds rate again next week. For the longer term, if the February and March GDP data do in fact herald the start of a period of real weakness, then the likelihood that the Bank's next rate move will be a cut will start to increase. 

The wrong kind of slowdown?

 At first glance, it might seem that the Q1 US GDP data released today suggest the Federal Reserve is close to achieving the hoped-for soft landing. The BEA's advance estimate shows that real GDP grew at an annualized rate of just 1.1 percent in the quarter, significantly slower than the 2.6 percent pace recorded in the final quarter of 2022 and well below the markets' consensus estimate of 2.0 percent.  However, a closer look at the details of the report indicates that the Fed's job may not be done just yet.

It is clear that the tighter monetary conditions imposed by the Fed over the past year are having an effect on some areas of the economy. The quarter saw a 12.5 percent annualized decline in fixed investment spending, reflecting lower business equipment spending and a further small fall in residential investment, which has now been declining continuously since mid-2021.

These declines were offset by increases in government spending and exports and, most significantly of all, consumer spending. The consumer sector accounts for fully two-thirds of the US economy, a higher proportion than in other developed economies. Despite rising interest rates, real consumer spending accelerated to a 3.7 percent annualized pace in Q1, the strongest print for any quarter since Q2/2021. Durable goods spending rose at a remarkable 17 percent pace, led by vehicle sales. 

Given the preponderance of the consumer sector in the economy, the Fed will not be able to assume that it has succeeded in slowing the economy until it sees weaker growth in consumer spending. Today's advance  report may of course be revised in subsequent releases -- the next update is due on May 25 -- but the numbers surely lock in the prospect of a further 25 basis point rate hike by the Fed at next week's FOMC meeting.  

Getting there

In line with market expectations, Canada's inflation rate slowed sharply on a year-on-year basis in March. Headline CPI rose 0.5 percent month-on-month, albeit only 0.1 percent on a seasonally adjusted basis.  However, the March 2022 jump of 1.4 percent (in the immediate aftermath of the Russian invasion of Ukraine) fell out of the year-on-year calculation, producing a powerful base effect. As a result, the year-on-year rise in March was 4.3 percent, down from 5.2 percent in February, representing the smallest rise since August 2021. As an aside, the fact that the August 2021 figure was 4.1 percent is a useful reminder that inflation was running well ahead of the Bank of Canada's 2 percent target long before the Ukraine invasion occurred. 

Two of the most widely-followed sub-indices, for food and gasoline, both contributed to the slowdown in headline inflation in March. Gasoline prices were 13.8 percent lower than a year ago, though a recent uptick in pump prices after OPEC's output cuts suggests that this will not be repeated in the April data.  Grocery prices, the subject of much political posturing in recent weeks, slowed to a still-newsworthy 9.7 percent annual gain in March from 10.6 percent in February. Again, this improvement may prove transitory, as flooding in California is set to boost produce prices again. Excluding food and energy, CPI rose 4.5 percent in the year to March, down from 4.8 percent in February.

The fastest-rising component of CPI in recent months has been mortgage interest costs, directly as a result of Bank of Canada rate hikes. This sub-index rose 26.4 percent in March from a year ago, the largest increase on record. Excluding mortgage interest costs, CPI rose 3.6 percent year-on-year, down from 4.7 percent in February. The Bank of Canada's three core inflation measures all fell significantly in the month, with the mean reading falling below 5 percent for the first time since April 2022. 

Today's data mean that CPI is finally below the Bank's overnight rate target and set to head lower still, which suggests rates have likely reached their peak for the current cycle. With the base effect set to remain strong in the next few months, headline CPI should continue to ease, in line with the Bank's expectation that it will reach 3 percent around mid-year. Beyond that, progress toward the 2 percent target will be slower, a fact underscored by the likelihood of higher energy and food prices in the near-term and the continuing impact of rate hikes on mortgage costs as more homeowners renew their financing. That last factor will remain important until such time as the Bank starts to reduce rates, which is unlikely to happen until early 2024

Pause on

In line with market expectations (and with its own commitment to a "conditional pause" in policy tightening) the Bank of Canada today kept its overnight rate target unchanged at 4.5 percent. If the Bank's outlook for inflation over the remainder of the year proves accurate, it looks likely that there will be no further rate hikes in this cycle. Details of the Bank's forecast can be found in the updated Monetary Policy Report, also released today. 

The Bank notes that global economic growth has surprised to the upside in recent months, but expects the pace to slow as past monetary policy measures take full effect. In the US, it notes that recent strains in the banking sector will further tightening credit conditions, so that US growth is expected to slow considerably in the coming months, with particular weakness in sectors that are important for Canadian exports.    As for Canada, the Bank has also seen growth above its previous projections in recent months, but as past tightening measures kick in,  GDP growth is projected to be weak through the remainder of this year before strengthening gradually next year. This implies the economy will move into excess supply in the second half of this year. The Bank now projects Canada’s economy to grow by 1.4% this year and 1.3% in 2024 before picking up to 2.5% in 2025. 

The Bank's update inflation outlook is definitely bullish. It expects year-on-year CPI, most recently at 5.2 percent, to fall to 3 percent by mid-year -- that base effect again -- and then ease more gradually to reach the 2 percent target by year-end. The Bank will pay particular attention to service sector prices, inflation expectations and wage growth as it monitors the situation in the coming months. In terms of the last of these factors, it notes that wage growth is still elevated relative to productivity growth.-- and is also, at least for now, above the inflation rate. 

Given this analysis, the Bank's decision to prolong the conditional pause was clearly the appropriate one. March CPI data, due next week, are expected to show another sharp fall in the yearly rate, and while April's result may be pushed higher by the latest rise in global oil prices, there is little reason to think that the Bank's outlook for CPI will prove to be seriously inaccurate. The Bank warns that it remains prepared to raise the policy rate further if needed to return inflation to the 2% target , but it seems increasingly unlikely that this will in fact be needed. 

Of course, a major influence and constraint on the Bank's policy actions is the stance of the Federal Reserve.  US March CPI data, released this morning, have triggered market optimism that the Fed may also be able to pause its tightening measures.  Headline CPI rose only 0.1 percent in the month, dropping the year-on-year rate to 5.0 percent, the smallest rise since May 2021. That's good news, but the stickiness of core CPI (+0.4% m/m, +5.6% y/y) may convince the FOMC that it still has work to do. Barring another flare-up in banking sector tensions, a further 25 bp rate hike on May 3 would be do surprise. 

A Fed-friendly jobs report

For once, market expectations for the US non-farm payrolls report were just about bang on the money. The BLS reported today that the US economy added 236,000 jobs in March, while the analysts consensus had called for 239,000.*  The unemployment rate edged down to 3.5 percent.  This was the smallest monthly gain in employment since December 2020. Perhaps a more useful comparison is to look back to the pre-COVID era: on this basis, today's report is the weakest for any month since December 2019.

The wage data remain more intriguing than the headline-grabbing employment numbers. Average hourly earnings rose 0.3 percent in March, dropping the year-on-year gain to 4.2 percent from the 4.3 percent posted in February.  The lack of upward pressure on wages may in part be explained by the gradual upward trend in both the labor force participation rate and the employment-population ratio, though both of these remain slightly below their pre-pandemic levels. An alternative explanation, of course, is that the Phillips-curve-based expectation that wages and inflation can only be kept in check if unemployment rises is simply incorrect. 

The Federal Reserve cannot base its rate decisions on just one month's data. That said, however, today's report looks for the most part to be Fed-friendly. Employment growth may finally be showing signs of easing to a more sustainable pace, while wage gains remain well in check (and well below the rate of CPI inflation).  The FOMC may not explicitly declare any kind of pause in tightening just yet, but there is no obvious need for any further rate hikes in the near term. 

* CNN described the print as "below expectations".  Given the nature of the report and the inevitability of revisions, this is ridiculous.  

Yet another upside surprise

Canada's job market continues to surpass expectations.  Statistics Canada reported this morning that the economy added 34,700 jobs in March, comfortably exceeding the consensus expectation for an increase of 12,000. The unemployment rate remained at 5.0 percent for a fourth consecutive month. 

In keeping with the recent pattern, most of the jobs created in the month were in the private sector, with 35,000 new positions, while public sector and self-employment were little changed. Almost 19,000 of the new jobs were full-time in nature. Ontario and Alberta led the increase, with Saskatchewan the only Province recording lower employment. 

One aspect of the report that will attract particular attention from the Bank of Canada is the growth in wages. Although the year-on-year gain in hourly earnings eased to 5.3 percent in March from February's 5.4 percent, this marked the second consecutive month that it has been marginally above the latest reported rise in CPI, namely the 5.2 percent gain reported for February.  March CPI data, due on April 18, are likely to show a further decline in headline inflation, widening the gap between earnings and prices. This is hardly evidence of the much-feared wage-price spiral*, but with the labour market remaining so tight, it will certainly influence the Bank's thinking regarding its "conditional" pause in tightening. 

Good Friday brings the release of the corresponding data for the US. the non-farm payrolls data for March.  Reports of mass layoffs in the tech sector and elsewhere have fed expectations that this may turn out to be the month in which the US employment picture finally turns sour, paving the way for the Fed to initiate a pause of its own. Stay tuned!

* Well, unless you count this guy.