Bracing For Rate Hikes
United States
The economy grew 6.9% annualized in the final quarter of 2021, well above expectations due to the second largest inventory build in 34 years. Despite the positive surprise and now cresting Omicron wave, we lowered our growth outlook in anticipation of less inventory restocking in coming quarters. Although the strong Q4 handoff keeps our annual 2022 growth call at 3.5%, the more telling Q4/Q4 rate was carved by half a percentage point to 2.6%, though this is still above potential growth of near 2%.
The Q4 GDP release showed two positive trends that testify to the economy's resilience. First, even as inflation absorbed every dollar increase in disposable income, and even as auto sales slid on limited selection, real consumer spending picked up to a 3.3% pace. While the holiday shopping season fizzled after starting early, 2021 still marked the best year for spending growth (7.9%) since 1946. New auto sales also rebounded nicely in January as automakers began to replenish inventories. Still, several forces are lining up totug shoppers in two directions in 2022. Pulling down will be budgetdraining price increases, higher interest rates, and the suspended extra child tax credit, while pulling up will be high household savings and the wealth effect. We suspect the tailwinds will dominate, as rate hikes won’t fully curb spending until next year. Households are using elevated savings to plug the holes in their budget drilled by inflation. We expect consumer spending to increase 3.5% this year, though it could be a full percentage point weaker if the expanded child tax credit is not reinstated.
The second positive trend revealed by the Q4 GDP report is that business spending on industrial equipment, computer gear, and software posted double-digit gains. Companies are rapidly investing in information technologies to address worker shortages. Many businesses are also pushing higher costs on to customers, shielding profit margins from inflation. Strength here, however, has been partly offset by continued weakness in commercial construction, which has risen only once in the past eight quarters and is down 23% since late 2019. Due to the uncertain long-term impact of remote working and online shopping, not many new office towers or malls are going up at the moment.
Savings-padded consumers and investment-driven businesses should drive a rebound in GDP growth to the 3%-to-4% range in the second and third quarters. This follows an expected downshift to around 1% in the first quarter due to worker illnesses and event cancellations caused by Omicron. After getting within 10% of pre-pandemic trends in November, indoor dining plunged 60% below 2019 levels in January. Still, despite Omicron, businesses expanded nonfarm payrolls by nearly half a million persons in each of the last two months, down only moderately from the prior two months and about three times faster than normal job growth. Although the unemployment rate ticked up to 4.0% due to an encouraging rise in the participation rate, it remains within earshot of the half century low plumbed before the pandemic.
The inflation outlook remains worrisome. Price increases are widespread as more companies pass higher costs to customers. Wage growth is rising due to worker shortages, made worse by Omicron illnesses. The employment cost index rose 4.0% y/y in Q4, the fastest in 20 years, There were a record 1.7 job vacancies for every unemployed person in December. Businesses are having some success filling jobs and drawing persons into the labour force by raising pay, but this is also adding to price pressures.The annual CPI rate is at four-decade highs of 7.0% in December and looks to rise further in the near term, before rolling over as base effects become friendlier in the spring. To date, there is little meaningful improvement in global supply chains, with U.S. ports still clogged and micro-chips in short supply. The New York Fed's new Global Supply Chain Pressure Index remains near record highs. However, global freight charges have pulled back from lofty heights, U.S. factories report some easing in supplier delivery times and order backlogs, and most retailers managed to keep shelves well stocked during the holiday season. Supply bottlenecks should ease as Omicron fades and goods demand cools, alleviating some price pressure. However, rising rent and wages will keep the CPI rate near 4% by year-end, well above the Fed's comfort zone.
Better late than sorry. The Fed has all but acknowledged that inflation likely won't retreat unless demand cools, meaning it's high time to end two years of emergency stimulus. Chair Powell said the Fed will take a "humble and nimble" approach, meaning everything is on the table to tame inflation, including a possible 50-basis-point hike, last seen in 2000. We expect rates to rise sooner, faster, and more than we previously thought, with 5 quarterpoint moves penciled in this year, starting in March, and another 100 bps next year. We also expect the Fed to start winding down its bloated portfolio of Treasury and mortgage bonds, starting in July. Quantitative tightening will fan the 10-year Treasury yield higher, likely to 2.1% by year-end and then to 2.6% in late 2023, from recent levels of 1.9%.
Canada
Despite flooding in British Columbia, Canada's economy ended the year on a high note with estimated growth of 6.5% annualized in the fourth quarter. A strong gain in November pushed GDP slightly above pre-pandemic levels. However, capacity restraints to address Omicron will likely stall the expansion in the first quarter of 2022. Indoor dining dropped 60% on average in January compared with 2019 levels, versus just 10% lower in November. Employment plunged 200,100 in January (or -1.0%), kicking the jobless rate up to 6.5%. Still, there were 32,500 more persons working than before the pandemic.
As in prior waves, jobs and activity should come storming back soon with most provinces now lifting restrictions. A rebound in accommodation, food services, and entertainment should help to lift GDP 7.0% in the second quarter and 4.0% for all of 2022, compared with estimated growth of 4.7% in 2021. Households are floating on a cushion of savings, though many are also highly indebted. One area ripe for improvement is business investment. Unlike the U.S., spending on equipment and intellectual property products remains below pre-pandemic levels, while commercial construction is down 17%.
Inflation isn't running as hot in Canada as in the U.S. or Europe, though the CPI rate of 4.8% y/y in December is still the highest in 30 years. The hope is that upward pressure on goods prices (6.8%) will ease as demand shifts toward services (3.4%), though the latter will be pressured higher by rising rent and wages. Inflation will likely stay elevated at 4.1% this year, before moderating to 2.5% next year, still above pre-virus levels and the central bank's mid-point target.
After pledging to keep policy rates at crisis-low levels for most of the past two years, the Bank of Canada is now warning loudly that rates "will need" to rise to control inflation. With the economy back at full employment, and fearing that high inflation might become ingrained in expectations, the Bank will begin normalizing policy at the March 2 meeting. Governor Macklem sees a "rising path" for rates, that is, a series of moves. We expect quarterpoint rate hikes at the next four meetings, with three additional increases taking the overnight rate to 2.0% by spring 2023. The 10-year Canada yieldwill rise less than policy rates, after spiking 75 bps last year and a further 35 bps this year in anticipation of tighter policy. We see the yield rising to 2.1% by year-end from recent levels of 1.85%.
As in 2021, the Canadian dollar remains range-bound against a strong greenback. Support from surging oil prices and the first string of current account surpluses in 13 years has been offset by the chance of the Fed outrunning the Bank of Canada to catch up with higher U.S. inflation. We look for the currency to appreciate moderately to US$0.81 (C$1.235) by year-end, supported by elevated commodity prices.
Risks
Although Omicron cases have crested, the possibility of a more lethal variant with the ability to evade vaccines remains a distinct threat. As well, additional waves of the virus could impede global supply chains, though most of Southeast Asia (with the notable exception of China) has shifted away from a “COVID-zero” approach now that vaccination rates are higher. Other threats to the economy stem from persistent high inflation and the need for aggressive monetary tightening, unsustainable house price increases in Canada and the United States, possible conflict between Russia and Ukraine, ongoing trade tensions between the U.S. and China, and a renewed decline in North American equity markets after January's stumble.