Still elusive

I used "That damned, elusive recession" as a title for a post back in November, when Canadian GDP data for Q3/2022 showed that six months of recession talk in the media had failed to tank the economy. Well, here we are six months later, looking at Q1 GDP data, and guess what?  Still no clear sign of a recession!

Statistics Canada reported this morning that real GDP grew at a 3.1 percent annualized rate in Q1, after a flat result in Q4/2022.  This was significantly higher than the market consensus expectation and well above the Bank of Canada's forecast for a 2.3 percent pace.  The growth was propelled by strong gains in household spending, after two sluggish quarters, and by a solid rise in exports. Housing investment, business investment and inventory accumulation all acted as a drag on overall growth, suggesting that the Bank of Canada's policy tightening over the past year is having an effect. 

StatsCan also released its monthly GDP data for March today. This showed virtually no change from February, a better result than the 0.1 percent preliminary estimate released a month ago. Of the 20 industrial sectors covered by the data, 12 posted higher output. In itself, the March figure might suggest a fairly weak "handoff" to the second quarter.  However, StatsCan's preliminary estimate for April indicates a 0.2 percent monthly increase in real GDP, again making an early recession unlikely. 

In themselves, today's data do not materially change things for the policymakers at the Bank of Canada. Growth per se is not the enemy here: the Bank is primarily focused on inflation and tightness in the labour market. The slight uptick in inflation last month was almost certainly only a temporary setback, but what about unemployment?.  The Bank's next rate decision is set for June 7. That happens to be two days before the labour force data for May are due to be released, but there can be no doubt that the Bank will be given an early glimpse of those all-important numbers.   

Maestronomics revisited

US media are somewhat disconcerted today by the news that "the Fed's favourite inflation gauge", the core personal consumption expenditure (PCE) deflator, ticked higher in April. In the distant past, the Fed mostly focused on CPI data, the same as the rest of the world, but the "maestro" Alan Greenspan put a stop to that. He engaged in a round of index shopping in an effort to find a measure that would allow him to do what he wanted to do, which was to keep rates low. First he settled on the Employment Cost Index (ECI), then when that started to misbehave he moved on to the even more obscure core PCE deflator. 

Would it be useful to do a comparison of the recent behaviour of these indices? Let's give it a go.

Headline CPI rose 4.9 percent in the year to April 2023, while core CPI (i.e. excluding food and energy) rose 5.5 percent. The cyclical peak for headline CPI was reached in June 2022, when it rose 9.1 percent from a year earlier.  

The ECI is a quarterly number, not monthly. For Q1/2023 it stood 4.8 percent higher than ayear earlier, compared to a rise of 5.1 percent in the year to Q4/2022.

The Core PCE deflator rose 4.7 percent in the year to April 2023, up from 4.6 percent in March but down from a reading of 5.2 percent in September 2022. It is worth noting that the monthly increase in the index for April, at 0.4 percent, is exactly in line with the average monthly increase seen over the past year. The all-items PCE deflator rose 4.4 percent in April, up from 4.2 percent in March. The annual increase in this measure was 5.4 percent at the start of 2023 and over 6 percent as recently as September 2022. 

Just a couple of observations on these numbers. First, ECI and the PCE deflators never peaked as high as the CPI figures, which is of course exactly why Greenspan glommed onto them in the first place.  Second, the relatively tame performance of the ECI, despite very tight labour markets, suggests that there is no real threat of a wage-price spiral*. Third, the fact that core measures for both CPI and the PCE deflator are lower than the all-items measures must be of particular concern for Fed policymakers. Food and fuel prices may grab the headlines, but it will not be possible to get inflation back to the target level unless more widespread price pressures are brought under control.  

Today's data may well help convince the Fed that it has more work to do, even though there is scant evidence that its rate hikes have had much to do with the decline in inflation over the past year. 

* It also suggests there is no validity to the Philips curve approach to policy, but I think I have flogged that dead nag enough. 

Actions have consequences

For much of the past year the Bank of Canada has been aggressively raising interest rates as it attempts to get inflation back to the 2 percent target. Its overnight rate target has risen from 0.5 percent to 4.5 percent, pushing up borrowing rates all across the yield curve. It is no surprise, then, that in its latest Financial System Review (FSR), published this morning, the Bank admits that it is "more concerned than it was last year about the ability of households to service their debt". 

Canada's high household debt has been on the radar for several years, not only at the Bank of Canada but also at international agencies like the IMF and OECD.  Low interest rates during the COVID era kept the lid on the problem, but it was always likely that stresses would begin to emerge once rates started moving back to more "normal" levels. That process is now underway, and the resulting problems are likely to continue to emerge over a period of several years.

In the Bank's words,  "While most households are proving resilient to increases in debt-servicing costs, early signs of financial stress are emerging". Thus far only about one-third of households have seen their mortgage payments increase, comprising those on floating rate mortgages and those unfortunate enough to have a rate reset in the past year. Since most Canadian "fixed rate" mortgages actually have a reset every five years or less, the percentage of households facing higher monthly payments will increase steadily right through 2026.  This fact alone makes Governor Macklem's warning that rate are unlikely to come down any time soon highly significant for the household sector.

In the meantime, amortization periods are already starting to stretch out. Fully 46 percent of new mortgages in 2022 had an amortization period of over 25 years, up from 34 percent in 2019.  The share of households falling behind on debt servicing is actually below its historic level, but has been rising since mid-2022. Moreover, it looks as if many households are only coping by running up credit card debt. Outstanding credit card balances are higher than they were pre-pandemic, with particular growth noted in credit card balances of newer mortgage borrowers. 

For now the Bank seems to think the situation is manageable, but it naturally worries about what could go wrong: "A severe recession with significant unemployment and further reductions in house prices could cause substantial financial stress for some households. Lower home equity could limit refinancing options on mortgages, leading to an increase in defaults. Credit losses to lenders would also rise if the liquidation value of a home in default is less than the value of the outstanding mortgage".

Aside from household debt, the FSR is reasonably upbeat about the stability of the system.  The Bank of Canada has some concerns over the possible impact of a severe recession on the banking system, but it points to "sound risk management and supervisory practices in Canada".  There are also sections of the report dealing stability issues with non-bank financial intermediaries, non-financial businesses, cryptocurrencies ("not currently significant"),  cybersecurity ("concerned")  and climate change ("significant"). It's a long list, but there is no doubt that it is the financial health of the household sector that haunts Governor Macklem's sleep at nights.  

Policy-driven inflation

A nasty little surprise in the latest Canadian inflation data this morning. Statistics Canada reported that headline CPI rose 4.4 percent in the year to April, up from 4.3 percent in March. That's above the consensus expectation for a 4.1 percent rise and marks the first time year-on-year inflation has moved higher since June 2022. There is quite a lot to get confused about in today's numbers, not least because the main factors driving the annual rate are currently not the same as those driving monthly changes; let's try to keep things straight. 

We can start with a quote from the StatsCan press release regarding the annual headline number:  On a year-over-year basis, higher rent prices and mortgage interest costs contributed the most to the all-items CPI increase in April 2023. In other words, the single greatest contributor to the rise in prices over the past twelve months seems to be the Bank of Canada's rate hikes. That doesn't mean that shelter costs are the fastest-growing sub-component of the index; that dubious honour still belongs to food prices, which rose 8.3 percent from a year ago, compared to 4.9 percent for shelter. However, the weighting of the index means that shelter contributed the most to the annual headline increase.

If we now turn to the monthly numbers, we see a somewhat different picture, but one that offers little comfort for the Bank of Canada. Seasonally adjusted CPI rose 0.6 percent in April, a number which annualizes to well over 7 percent, far above the Bank's 2 percent target.  The biggest contributor to the monthly increase was the price of gasoline, which jumped 6.3 percent in the month, although it remains 7.7 percent lower than in April 2022. StatsCan cites the recent OPEC production cut as a key factor behind the increase and also mentions "an increase in carbon levies", specifically an increase in the much-despised Federal carbon tax that was imposed at the start of the month. The impact of the OPEC move has already proven to be largely transitory, but the tax increase will, of course, stay in place.

All of this adds up to a conundrum for the Bank of Canada. It can take some small comfort in the fact that its three "preferred" measures of underlying inflation all eased in the month, although their mean value remains above 5 percent. However, the fact that the monthly increase in April was so substantial makes it less likely that its earlier forecast that CPI will fall to 3 percent around mid-year will be realized. Markets are starting to price in a growing possibility of a 25 basis point rate hike at the next Governing Council meeting on June 7. For the moment that is not the likeliest outcome, but any more inflation numbers like today's will put the Bank's "conditional" pause under greater threat. 

US April CPI: hold your applause

It's the headline number that has dominated the headlines today. The BLS reported this morning that US headline CPI rose 4.9 percent in the year to April. That's down from 5.0 percent in March and marks the lowest year-on-year increase since April 2021. 

Sad to relate, the good news really starts and ends with that headline figure.  For some time, I have been saying in this blog that the monthly changes are much more important to analyze and understand than the annual figure. Inflation on an annual basis has fallen steadily for almost a year, mainly thanks to the "base effect". The annual number is literally old news: most of it reflects actual price movements that took place many months ago. Particularly in early 2022, there were very large increases in CPI from month to month, resulting in rapid growth in annual headline CPI number.  As those monthly numbers began to ease around mid-2022, the annual rate began to fall, slowly but steadily. Media reports that focused on the annual number routinely missed the fact that the monthly numbers were starting to look a lot less threatening. 

Now the shoe is on the other foot. Last year's jumbo monthly increases are now largely out of the annual headline calculation, so the annual increase is more accurately reflecting the impact (or lack thereof) of the the Fed's tightening actions. This is where today's report is disappointing for anyone who is tempted to believe the Fed's job is largely done. Both headline and core (ex food and energy) CPI rose 0.4 percent month-on-month in April. That annualizes to just over 5 percent for both indices, obviously far above the Fed's 2 percent target. The easy part is over: getting inflation down to the target rate, with no further assistance from the base effect, is going to be a slow process. 

There is further cause for concern in the details of the data. The big surge in inflation in 2021 and 2022 was largely attributable to rises in goods prices, reflecting first COVID-related supply chain issues and later the impact of the Russian invasion of Ukraine. It has always been arguable (and has been argued here) that Fed interest rate hikes are the wrong tool to use to combat such inflation. 

Now, however, goods price inflation is clearly ebbing. Energy and other commodity prices are no longer rising, and even the previously stubborn food at home index has started to move lower in the last two months.  However, prices for services are now becoming a headache for the Fed. Overall service prices are up 6.8 percent from a year ago, led by an 8.1 percent increase in shelter costs, and the monthly numbers show no signs of slowing. 

As a colleague of mine used to say, "you can't go to Beijing for a haircut". Or to Kyiv, for that matter. Inflation in services prices is home-grown, and the Fed will be watching anxiously in the next few months to see if its past policy actions will finally start to have an impact. 

This is a slowdown?

Media on both sides of the border are talking up the prospects for an early recession, and markets are starting to price in the possibility of rate cuts by the end of this year. However it seems that nobody has told the labour markets, because April employment data for both Canada and the United States show continuing strength. 

In Canada the economy added 41,000 jobs in April, with the unemployment rate unchanged at 5.0 percent for a fifth straight month. There is one notable change in the composition of the data that may or may not prove to be a turning point: all of the new jobs in the month represented part-time work. This is the first significant increase in part-time employment since October 2022 -- almost all of the impressive job gains recorded since then have been full-time positions. 

One element of the monthly jobs report that the Bank of Canada is undoubtedly keeping a close eye on is the behaviour of wages. Monthly wages rose 5.2 percent year-on-year in April, the third consecutive month that they have outpaced the growth in headline CPI.  There is still no sign of any sort of wage-price spiral, but the Bank will be monitoring to see whether the 12.6 percent raise won by public sector workers, albeit spread over a four-year contract,  starts to trigger larger wage demands elsewhere in the economy. 

In the United States, the BLS reported that the economy added 253,000 jobs in April, leaving the unemployment rate unchanged at 3.4 percent. The report came in well ahead of expectations, though there were some significant downward revisions to some of the job gains initially reported in previous months. In contrast to the situation in Canada, wage gains in the US remain below the rate of inflation, with average hourly earnings up 4.4 percent from a year ago. 

It is unlikely that today's reports will have any significant impact on the policies of the respective central banks in the near term. The Bank of Canada has formally declared a "conditional" pause in tightening while the Fed, despite raising rates again this week, has come close to suggesting its tightening cycle is over for now. However, until there are unmistakable signs that the employment market in both countries is losing momentum, speculation about an early start to rate cuts is entirely premature. 

You sure about that?

The Federal Reserve today raised the funds target by 25 basis points, bringing it to 5.25 percent. The decision was in line with market expectations, but the almost insouciant tone of the FOMC press release comes as something of a surprise, given the continuing instability in the banking system and the looming debt ceiling crisis. 

The problems in the banking sector are airily waved away in a single sentence, right at the start of the release: "The US banking system is sound and resilient".  This is followed by the statement that "Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring and inflation".  "Weighing on" those things was, of course, precisely the goal of the Fed's tightening all along, but it is unlikely that its vision of a soft landing included the messy collapse of several large banks.  Some acknowledgement that recent events in the financial system are at least in part the result of Fed actions might not have gone amiss, if only to reassure investors that the Fed knows it cannot afford to push things too far.  Fed Chair Powell will no doubt face extensive questioning on this topic from the media. 

As regards the current state of the economy, the Fed has very little to say: "Economic activity expanded at a modest pace in the first quarter. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated".

The rest of the press release is simply a restatement of the customary boilerplate: "The Committee remains highly attentive to inflation risks" and "is strongly committed to returning inflation to its 2 percent objective".  As usual, "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".  The vote in favour of all this was unanimous: we will have to wait for publication of the minutes later this month to learn whether any Governors may have argued for keeping rate unchanged this time. 

The debt ceiling crisis, now less than a month from coming to a head, is not mentioned at all in the release, though it must surely have come up for discussion. The Fed must have a game plan in mind if the worst should happen, but it is unlikely to reveal any details ahead of time, in case it inadvertently makes matters worse. Would the Fed accept the much-discussed trillion dollar platinum coin, should the Treasury Department choose to mint one? That's something else we shall have to wait to find out.