Recession watch update: there's no recession

Statistics Canada reported this morning that Canada's GDP edged down by 0.3 percent, or 1.1 percent at an annualized rate, in the third quarter of the year.  Since GDP growth for Q2 was originally also reported as a small decline, this means the economy is "officially" in a recession, right?  Well, no, because that decline in Q2 has been revised away, with real GDP now posting a 0.3 percent increase for the quarter.  So the media's much-longed-for recession remains evasive, and preliminary data suggest it will not arrive in Q4 either. 

The decline in real GDP in Q3 reflected several factors, some of which may well prove temporary. Exports were lower in the quarter, with the decline surprisingly led by a sharp fall in shipments of refined petroleum products. Although global oil markets are weak, this is unlikely to be repeated in the current quarter. There was also a marked slowdown in inventory accumulation, while household spending was flat. Housing construction increased for the first time since early 2022, a welcome development in light of the immigration-driven rise in population. All in all, the quarterly data depict an economy that is trending sideways rather than one that is poised to fall off a cliff.

Then there are the monthly data, which are always updated alongside the quarterly figures, although they are calculated on a somewhat different basis. StatsCan reports that real GDP grew 0.1 percent in the month, with a strong rebound in manufacturing output partly offset by reduced raw materials production. StatsCan also provided an initial estimate for October, showing that real GDP posted a 0.2 percent gain as raw materials extraction bounced back from the previous month's weakness.  The combination of the strong-ish "handoff" from September and the October gain means that the economy would have to post a significant decline in November and December to produce a decline in GDP for Q4 as a whole.  Yet again, then -- no recession for now.

The recessionophiles in the media and online, in Canada and elsewhere,  have recently started to talk about a "per capita recession". I know what this is and I daresay my esteemed readers do too, but I can't say it's a term that saw much use until the old-fashioned type of recession obstinately refused to show up.  That said, it's a meaningful concept, especially in Canada where population growth is currently so rapid.  Canada is unequivocally in a "per capita recession" right now, a development that likely goes a long way towards explaining the sour mood that voters express when they talk to opinion pollsters. "Per capita recession" equals falling living standards, something governments ignore at their extreme peril. 

Whether we are talking about GDP in the aggregate or on a per capita basis, today's data confirm that there is no likelihood of any further Bank of Canada tightening.  Talk of early rate cuts seems premature, however.  As long as real GDP is still edging forward, the Bank has the luxury of waiting to make sure that inflation really does come all the way down to the 2 percent target. 

Road to nowhere

Canada has been down this fiscal path before. Back in the 1980s, under a succession of deservedly  forgotten Conservative Finance Ministers, it was never quite the right time to rein in the budget deficit. That task eventually fell to the Chretien/Martin Liberal governments of the 1990s.  How they did it is not well recalled and is relevant to what the present government and its successors may find themselves facing in the next few years.  We shall come back to that. 

When Justin Trudeau came to power in 2015 he inherited a minute budget surplus from the Harper Conservatives. Trudeau had campaigned on a promise to run small deficits for a short period of time in order to boost growth. It quickly became apparent that the deficits would be neither as small nor as temporary as Trudeau promised -- and then came COVID.  The government correctly boosted spending sharply to cushion the pandemic's impact on the economy, and as revenues fell, the deficit skyrocketed to unprecedented levels.

Tabling her Fall Economic Statement on Tuesday afternoon, Finance Minister Chrystia Freeland alluded to the impact of COVID on the fiscal situation, citing the most severe economic slowdown since the Depression.  Here's the thing though: the downturn in the economy in the first half of 2020, severe though it was, lasted barely long enough to meet the "official" definition of a recession, i.e. two quarters of declining output.  By the second half of that year the economy was rebounding sharply, and a solid rate of growth was maintained through 2022.

The temporary spending schemes hastily put in place in 2020 were gradually unwound as the pandemic waned.  However, instead of bringing the deficit back under control, Trudeau and Freeland decided that the funds should largely be redeployed into new spending initiatives, so deficits remained far larger than originally projected. The Bank of Canada, and increasingly the business economics crowd, have been arguing ever louder that this fiscal stimulus directly contributed to the persistence of an above-target level of inflation, which in turn forced the Bank of Canada to raise interest rates substantially.

Thus we arrive at the economic background to yesterday's economic statement:  a slowing economy, sluggish growth in revenues, a raft of post-COVID spending commitments, urgent new spending needs (especially for housing) and the rapidly rising cost of servicing the soaring government debt.  Courtesy of higher interest rates that may well be in large measure the government's fault, debt service costs are set to rise so quickly that even if the government were prepared to contemplate meaningful spending cuts -- which it emphatically is not -- the deficit would still be an almost intractable problem.  

The actual content of the economic statement itself is pretty flimsy stuff. The Government's economic projections, as is usual these days, reflect those of non-Ottawa economists. In the base case, the economy is expected to avoid a recession by the skin of its teeth, with growth of just 0.4 percent next year. Inflation is expected to keep moving lower, which is of course not positive for the  revenue growth outlook.  Unemployment, which has already been moving higher in recent months, is expected to rise by almost another full percentage point next year, to 6.5 percent.

Under these assumptions, the base case forecast for the deficit in fiscal 2023/24 (ending in early April) is C$ 40 billion, just about identical to what was tabled in last Spring's budget.  Beyond this year, however, the situation looks markedly worse. In the budget, the deficit was projected to narrow fairly steadily over the five-year forecasting horizon, reaching C$ 14 billion by FY 2027/28. The new projection shows essentially no narrowing of the deficit in either of the next two fiscal years, and the deficit at the end of the planning horizon is now projected at C$ 18.4 billion.  "Downside scenario" numbers are of course considerably worse.

The Government can try to portray itself as being helpless in the face of adverse developments here, but that is not the whole story. The fiscal outlook table reveals that "policy actions" since the Spring budget have already added about $ 6 billion to the cumulative deficit over the first three fiscal years of the planning horizon.  Adding in the new measures announced by Freeland yesterday, the Government is now planning to boost spending by a cumulative C$ 20 billion over the full five-year horizon.  Presenting this as "fiscal prudence" is unlikely to convince many voters, let alone opposition politicians. 

That new spending is mainly focused on the housing sector, which faces something of a perfect storm as a result of rising mortgage rates and rapid population growth.  Provinces and municipalities are crying out for immediate help, but Trudeau and Freeland have perversely chosen to back-end-load the new funds. Much of the money will not be available until FY 2025/26 when, surely by pure coincidence, the next election is likely to be called. One measure that will take effect sooner is an attempt to crack down on the likes of Airbnb, but given the wiliness of buy-to-rent investors, it remains to be seen how much that can achieve.

It's a problem largely of the Government's own making. Suggestions that Canada will soon hit some kind of a "debt wall" are off the mark -- that need never happen to a sovereign currency issuer -- but the way out of the mess is hard to discern. How did Chretien and Martin pull it off back in the 1990s, and can the current hapless pair do the same?

The big innovation made by Paul Martin as Finance Minister was to shorten the planning horizon. His Conservative predecessors had always promised lower deficits in the "out years", but as budget succeeded budget, the reductions kept getting pushed into the future. Martin cut the horizon to two years but insisted that the spending ministries actually obeyed the targets that were set in each budget, with no backsliding. What had seemed an intractable problem was largely eliminated in less than a decade.

Ever since that time, Liberals have taken the occasional victory lap to remind people of how they cut spending in the 1990s.  One former minister even pitched up in London when I was living there, offering his deficit-slaying expertise to the Cameron government.  The problem with that is that it is not entirely true.  There were some spending cuts in the mid-1990s, but by the decade's end almost all categories of spending were as high or higher than they had been when Martin took on the job.  What really closed the fiscal gap was a startling rise in revenues, which soared by more than 60 percent over the course of the decade. For that, thank a strongly-growing US economy fueled by the low interest rate policies of the Greenspan Fed. 

That lesson from history is not an encouraging one for the Trudeau government.  The US economy has been outperforming Canada's and interest rates, though higher than they were two years ago, are still not high by historical standards.  Despite this relatively helpful background, Canada's fiscal situation has deteriorated sharply, mainly thanks to spending decisions consciously taken by the current economic team.  The next Finance Minister, be they Liberal or Conservative, is going to face a truly tough task. 

Apologies for the unusually long post, but it's depressing to see such a complete failure to learn the lessons of the past. 

Gimme shelter

Canada's headline CPI was virtually unchanged in October from the previous month -- up 0.1 percent unadjusted, down 0.1 percent seasonally adjusted -- according to new data today from Statistics Canada. This lowered the year-on-year rate to 3.1 percent for October from 3.8 percent in September, in line with market expectations. The data certainly reinforce the likelihood that the Bank of Canada's rate hike cycle is at an end, but the details show that it is still premature to be thinking about rate cuts. 

The main contributor to the sharp slowdown in the year-on-year headline rate was a 7.8 percent fall in gasoline prices.  If gasoline is excluded from the calculation, the fall in the year-on-year rate was much smaller, easing to 3.6 percent in October from 3.7 percent in September. It goes without saying that the Bank of Canada can claim little credit for falling gasoline prices, and in any case the situation in the Middle East means that further softness in this important component of the index cannot be relied upon.

In terms of the other main components of household spending -- food and shelter -- the story is rather less positive. Food prices ticked down by 0.1 percent in October but still stand 5.7 percent higher than a year ago.  This is significant,  given that food inflation peaked at more than 10 percent, but it is highly unlikely that this improvement owes much, if anything, to the Federal government's attempts at jawboning the major grocery chains into cutting prices.

The story for shelter is possibly even worse. Rents accelerated to an 8.2 percent year-on-year gain in October from 7.3 percent in September, while mortgage costs are more than 30 percent higher than a year ago. As a result, the shelter sub-index is the fastest rising component of the CPI, up 6.1 percent in the past year.  Given the importance of interest rates as a driver of shelter costs, this is one element of the overall CPI that can clearly be said to be within the Bank of Canada's control, although rapid population growth as a result of record high immigration is certainly not helping. 

The Bank of Canada's three preferred measures of core inflation all fell modestly in October. However,  their mean value is still only just below 4 percent.  Given the Bank's regular restatement of its intention to get CPI all the way back to the 2 percent target, it is apparent that rate cuts will not be on the agenda for many months yet.

So now we await Finance Minister Chrystia Freeland's Fall economic statement later today. Bay Street economists are increasingly outspoken in their view that rapid growth in government spending has been a major factor in driving interest rates higher -- see, for example, this article from Scotiabank. The Trudeau government is clearly starting to set out its stall for the next election, so an austerity budget is not on the cards.  However, any evidence of further fiscal profligacy will be quickly seized upon by the Conservatives. Expect any new initiatives to be focused on the housing sector, and expect Freeland to bend herself into a pretzel trying to argue that a deficit north of C$ 40 billion represents fiscal responsibility. 

Reading too much into single data points

Something business economists are taught to avoid is reading too much significance into individual data points about the economy.  Seasonal adjustments, measurement problems, weather and a host of other things mean it is very important to look at as many data points as possible before declaring a trend.  It's a lesson that seems to have been forgotten by quite a number of commentators as they looked at some important numbers this week.

On Tuesday the Bureau of Labor Statistics released consumer price index data for October.  The headline number was certainly encouraging: prices were unchanged in the month, which resulted in the year-on-year inflation rate easing to 3.2 percent from the 3.7 percent reported in September. Equity markets rallied hard on hopes that falling inflation would pave the way for the Fed to start cutting rates sooner rather than later.

A look behind the headline suggests that a more cautious interpretation of the data might be in order. The lower-than-expected headline print was largely the result of a 5 percent month-on-month decline in the price of gasoline.  That's not something that Fed policymakers can claim any credit for, and given the highly volatile situation in the Middle East, it's not something that can be counted on in the months ahead, even though a similar outcome now seems likely for November.

Other sub-components of the index were less positive from a policy standpoint. Both shelter and food prices rose 0.3 percent in October, with shelter prices up 6.7 percent higher than they were a year ago. CPI less food and energy stands 4.0 percent above its year-ago level.  Given that Fed Chair Jay Powell always insists that the Fed intends to get CPI all the way back to the 2 percent target, that suggests there is still some way to go before lower rates can be confidently predicted.  

Today the US Commerce Department provided its advance estimate of retail sales for October. The dollar value of retail sales (not adjusted for inflation) edged down by 0.1 percent from September, the first such  decline since March.  However, the monthly decline was actually smaller than markets had expected, given the very robust 0.7 percent increase initially reported for September. What's more, that September increase was actually revised higher to 0.9 percent, which means that the dollar value of retail sales in October was significantly higher than markets had foreseen, even if sales fell marginally in the month.

With the holiday shopping season yet to get fully underway -- Black Friday and Cyber Monday are still a week away -- it would be foolhardy to suggest that one month of not-actually-weak data on CPI and retail spending sets the stage for the Fed to start contemplating early rate cuts. We can be quite sure that that is not how the Fed sees it. 

Softer job growth in October

Both the Federal Reserve and the Bank of Canada have recently signalled that they are prepared to keep rates on hold for the time being, while waiting to assess the effect of their past tightening moves.  Both central banks have indicated that their future rate decisions will be, to use an old cliche, data dependent, with developments in the labour market very much front of mind. Employment data for October, released in both countries today, suggest that both banks may be able to avoid any further tightening. 

In the US, data from the Bureau of Labor Statistics show that the US economy added 150,000 jobs in October. This was below market expectations and marked a sharp fall from the 297,000 jobs added in September.  That September number was revised down from an initial estimate above 330,000.  The October number is also materially below the average monthly gain of 258,000 jobs created over the past twelve months. The unemployment rate ticked higher to stand at 4.9 percent. 

Importantly for the Fed, there is still no evidence of significant upward pressure on wages. Average hourly earnings rose a scant 0.2 percent in October, the same as in September. This brought the year-on-year rise to 4.1 percent, down from 4.2 percent a month earlier.  

In Canada the story is similar in many ways, but with the added complication that the labour force is growing extremely fast because of high immigration. After adding an aggregate of more than 100,000 jobs in August and September, the economy added only 18,000 positions in October.* With the labour force growing by almost 58,000 in the month, this pushed the unemployment rate up by 0.2 percentage points to 5.7 percent, by coincidence identical to its pre-pandemic level. 

The impact of immigration on the size of the labour force shows up even more starkly on a longer view. Since January, employment has grown by an average of 28,000 per month, but the monthly increase in the labour force has been over 80,000. It is thus no surprise to see the unemployment rate moving up steadily from the cyclical low of 4.9 percent reached in mid-2022. It is also worth noting that the Federal government seems to be realizing, however belatedly, that the current situation is unsustainable. It announced this week that it intends to stabilize immigration levels, although not until 2026.

As in the US, wage gains in Canada remain relatively restrained. The year-on-year rise in average hourly earnings slipped to 4.8 percent in October from 5.0 percent in September,  However, in light of numerous high-profile labour disputes in recent weeks (the Big Three auto makers, the St Lawrence Seaway and many others), this is something the Bank of Canada will continue to monitor closely.

All in all, these are Fed-and Bank-friendly numbers.  One month of data is far too little to declare a trend, but things do seem to be moving in the direction policymakers want. 

* Interestingly, the construction sector accounted for all of the net new jobs in the month.  Given well-founded concerns over where all the immigrants are supposed to live, this presumably counts as welcome news. 

Fed does the expected thing

As expected, today's meeting of the FOMC ended with the Fed deciding to keep its Fed funds target range unchanged at 5.25-5.5 percent. The press release starts with a recitation of economic developments that might, in the abstract,  point to the need for higher rates, but then explains why the Fed is content for now to see whether its past tightening moves are enough to get inflation back to the 2 percent target.

The first paragraph, quoted here in full, would need very little amendment if the outcome of the meeting had in fact been another rate hike:

Recent indicators suggest that economic activity expanded at a strong pace in the third quarter. Job gains have moderated since earlier in the year but remain strong, and the unemployment rate has remained low. Inflation remains elevated.

However, the release then goes on to list the Committee's rationale(s) for keeping things unchanged for now.  These include:

Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain.

and

In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

The FOMC is of course quick to restate its ultimate goal: The Committee is strongly committed to returning inflation to its 2 percent objective. Market participants now seem to have taken on board the message that rates are likely to stay at current levels for much longer than was previously anticipated, with a full return to the 2 percent target not anticipated until 2026. Whether further rate hikes will be needed to meet that goal is still an open question, but today's announcement makes it clear that further upside surprises in growth or employment could yet push the FOMC in that direction.