Monthly Economic Letter

May 2021

Feature article

Guess who's back? Spoiler: it’s inflation

After more than a decade of low inflation, indicators are starting to show that prices are on the rise. The consumer price index (CPI) increased to above 2% in March. Many businesses are facing higher costs, and increasingly, they are passing the bill on to consumers. But inflation’s comeback will probably be short-lived.

A low base makes inflation appear stronger

There are several measures of inflation, but they are all calculated the same way. The inflation rate is the change in a price index relative to the level measured at the same time the previous year.

Since Canada’s price index fell drastically at the start of the pandemic in March 2020, a moderate increase in prices in March 2021 resulted in a significantly higher inflation rate.

The CPI returned to its pre-pandemic level only in October. Therefore, inflation rates in the coming months will continue to appear high relative to low readings last year.

Price increases are still very real

Despite this base effect, price increases are occurring. However, several factors lead us to believe this uptick in inflation won’t last.

A key element in the higher inflation we are seeing is an increase in commodity prices over the past year. In fact, production costs in general have been rising. Several factors explain these price increases.

First, the pandemic disrupted the usual consumption patterns of individuals. Purchases of services were limited by lockdowns while demand for goods increased.

Demand for products such as metals and minerals, lumber and agricultural products surged. Supply of these types of products needs time to adjust to the sudden increases in demand, leading to higher prices. The pandemic has also created supply-chain bottlenecks, causing further pressure on industrial production costs.

Inflation could get worse

At the same time, stimulative monetary and fiscal policies have led to a lot of liquidity in the economy.

While there is still a great deal of uncertainty as to when the pandemic will be over, the acceleration of the vaccination campaign should lead to a reopening of the Canadian economy within a few months. The reopening could mean a sudden increase in the speed at which money circulates in the economy, adding to inflationary pressures.

The Bank of Canada expects a moderate increase in consumption as households spend the savings they’ve accumulated during the pandemic. What would happen if households decided to spend more than expected? Yes, more inflation. This is a very real risk as some reopened economies have seen a surge of consumption from people who have been couped up at home for months.

There is a but...

It’s important to distinguish short-term or transitory inflationary pressures from systematic and structural ones. While commodity prices are expected to continue to rise this year and probably well into 2022, supply will adjust to meet demand. This should bring prices back to more stable levels.

It’s also important to remember that although uncertainty and restrictive measures remain across the country, many consumer trends we’ve seen during the pandemic will not continue in a post-COVID environment. Consumption preferences are expected to readjust as economies reopen, and household budget priorities will change.

Meanwhile, the Bank of Canada has already taken a step towards a tighter monetary policy. The bank was ahead of all other central banks in starting to reduce its asset purchases from $4 billion per week to $3 billion. It could end its asset purchase program completely by the end of the year, which should help to calm inflation expectations somewhat.

We’re not talking about a permanent spike in inflation

There is no doubt inflation will rise in the coming months. But we don't expect the kind of big spikes seen in the 70s and 80s as long as monetary and fiscal policies adapt to the situation.

However, transitory inflation doesn’t mean the status quo either. The Bank of Canada will raise its policy rate eventually. In fact, its rate review been moved up to 2022 from 2023 because of a better economic outlook.

The impact on your business

  • Inflationary pressures are here and entrepreneurs are on the front lines. They face significant cost increases. The good news is that most consumers and businesses are in good shape to absorb price increases.
  • The inflation we see in the coming months should not be the beginning of a new trend, but a transitory effect of the economic recovery.
  • The reopening of the economy and a favourable economic outlook should still push the Bank of Canada to raise the policy rate as early as the second half of 2022. That said, any tightening of monetary policy will likely be slow and gradual.

Canadian economy at a glance

A first quarter that beat expectations

We’ve been saying it for a few months now, but the Canadian economy has managed to remain healthy in 2021 despite the pandemic. The economic data is such that the Bank of Canada has revised its growth forecast to 6.5% for the year. That's 2.5 percentage points better than what was initially forecast in January.

Economy shows sustained growth

Monthly GDP growth continued in February with a gain of 0.4% over January. This is the tenth consecutive month of positive growth for the country.

Even so, overall GDP is still a few points short of the February 2020 (pre-pandemic) level. That's because high-contact sectors, such as food service, entertainment and accomodation, are still struggling. The latest wave of COVID and health restrictions to limit its spread continue to hold back the recovery in these sectors.

Preliminary estimates from Statistics Canada suggest a GDP increase of 0.9% in March, which would mark the strongest monthly growth since August 2020, the start of the second COVID wave.

Monthly growth of this magnitude would bode well for a full recovery in GDP by early summer. However, a broad-based reopening of the Canadian economy will only be possible once herd immunity is achieved, which may take longer.

When opening leads to growth

At the heart of an economic recovery is consumption. Not surprisingly, retail sales grew well in February. In fact, sales increased by 4.8% compared to January in dollar terms and by 4.3% in volume.

Obviously, these good results are partly due to the reopening of stores that had closed in January. Retail sales in Quebec were particularly impressive. The province recorded a 19% increase over the previous month.

This excellent showing indicates that once restrictions are lifted, consumers will be ready to spend. On the other hand, the data also suggests the recovery of provincial economies will be out of sync due to different lockdown timelines.

Online shopping continues to be an option in areas where stores are still closed or where product availability is limited by health measures. Online sales declined between January and February—likely due to the reopening of stores in some provinces—but remain up sharply from last year.

They were up 114.5% in January and 89.6% in February compared to the same period last year.

One step forward, one step back

Employment fell by 207,000 in April. As expected, gains made in March in high-contact sectors such as food services, accommodation and arts and culture were completely given back in April. This was also the case for the wholesale and retail sector. Once again, we can blame the latest wave of COVID-19.

The country is still half a million jobs short of its pre-pandemic level. The decline in the accommodation and food services sector accounts for 70% of the overall Canadian employment deficit.

Going forward, employment gains will reflect progress against the virus. With various provinces opening up vaccinations to all adults in the next few weeks, the stage is set for a strong employment recovery in June.

The impact on your business

  • Vaccination campaigns are gaining momentum across the country. While it's been difficult for businesses to feel the impact in recent days due to the third COVID wave and ongoing restrictions, the reopening of the economy is at hand.
  • Strong retail sales in February should be a reminder to entrepreneurs that when businesses reopen, consumers will be ready to spend.
  • The third wave and the new health measures will have taken their toll on the labor market in April. However, once again, herd immunity from vaccines is coming, which bodes well for an easing of restrictions and a recovery in employment.

U.S. economy at a glance

Towards a new peak

Last year, the United States was slow to respond to the pandemic and the result was a disastrous 29 million COVID cases and over half a million deaths. However, a well-organized vaccination campaign has the U.S. on the offensive in its fight against the virus. And it's reflected in the economy.

Economy returns to pre-pandemic size

The U.S. recovery is slightly outpacing the one in Canada, with first-quarter GDP south of the border hitting an annualized rate of 6.4% compared to the last quarter of 2020. U.S. GDP is now less than 1% below its pre-crisis level (Q4 2019).

Government stimulus cheques probably paid off in stronger economic activity. Americans received two government transfers directly into their pockets during the quarter, the first in January and the second in March. Consumer spending in the U.S. jumped by 10.7%.

However, increases in real disposable income (+61.3%) and the savings rate suggest that much of the money is still sitting in bank accounts. U.S. household savings reached 20% of disposable income in the first quarter.

The easing of health measures continues across the country. Households that are flush with cash should, therefore, continue to support rapid growth in the second quarter.

Employment stalled, once again, in April

The easing of restrictions and the stimulus package did not have the impact on the job market that was expected in April. While the consensus expectation was for job gains over one million, the U.S. economy added only 266,000 jobs during the month. Moreover, job gains in March were revised downward to 770,000. A drop of almost 150,000 jobs compared to the initial estimate of 916,000.

The gains, while disappointing, came primarily from consumer-facing businesses and are therefore largely attributable to the easing of restrictive measures in the country. The leisure and hospitality sector, in particular, increased by 331,000 between March and April. The rebound in the labour force participation has offset the number of jobs recovered which brought the unemployment rate from 6.0% to 6.1%.

The Federal Reserve remains cautious

Despite the optimism and solid economic recovery, nothing seems to be shaking the Federal Reserve’s determination to continue support for the economy.

Chairman Jerome Powell has not even hinted at changing the direction of monetary policy. The Fed believes fears of kindling long-term inflation are unfounded. It insists a flare-up in inflation in coming months will be a transitory effect of the recovery.

Room for growth

Despite the rosy picture of the first quarter, the U.S. economy still has room to grow. Domestic demand is strong and the reopening of the economy bodes well for the service sector, which lags behind goods producing industries. Already in March, the service sector's purchasing managers' index climbed to an astonishing 60.4. April's index was even higher at 64.7—an all-time high signalling a sharp pace of expansion for the sector.

Additionally, the country is still experiencing excess capacity in the labour force, with over 8.2 million jobs still to be filled before the February 2020 peak is reached.

The impact on your business

  • U.S. demand has already recovered well and the trend is expected to continue in the coming months. As our major trade partner, Canadian companies should benefit from the strong American rebound.
  • Contrary to the Bank of Canada, the Federal Reserve has not changed its monetary policy and there appears to be little prospect of tightening anytime soon. This should push the Canadian dollar higher against the U.S. dollar. Prepare for a rise in the exchange rate.
  • Employment lags behind economic and consumption recovery in the United States. The labour market update of April supports the Federal Reserve's view that an inclusive return to full employment will take several months despite the favourable economic and health environment.

Oil market update

Oil rebounds, but the pandemic is still cause for concern

Oil benchmarks rose in April despite a global surge in COVID-19 cases. Brent crude was trading at US$67 per barrel while West Texas Intermediate (WTI) hovered at around US$64 per barrel.

The recovery of the U.S. economy, a weak U.S. dollar and a stronger global economic outlook have outweighed concerns about a spike in COVID-19 cases around the world, specifically in India, since mid-April. However, the situation is now alarming in that country, which is a major oil importer.

Where is demand for crude headed?

Oil demand will depend on the evolution of the global pandemic and the economic recovery. Right now, these two forces seem to be offsetting each other.

Although new daily COVID cases have reached new highs globally, demand for oil has been revised upward by many observers. The economic outlook has improved in several industrialized countries, and the reopening of these economies should partially offset slowdowns elsewhere in the world.

At the top of the list of positive developments is brightening prospects in the U.S. Vaccination campaigns are moving so quickly that every adult American who wants one should have received at least a first dose by the end of June. This suggests that the full reopening of the economy will be brought forward. Even New York City expects to fully reopen by July 1.

Obviously, as the main consumer of oil products, the return to high levels of activity in the U.S. explains most of the revision of world oil demand by the International Energy Agency in its April report. According to their forecast, demand will increase to 96.7 million barrels per day (mb/d) in 2021, up 5.7 mb/d from last year. First quarter forecasts were trimmed due to lockdowns in Europe, but upward revisions for subsequent quarters offset the decline.

This forecast was made before the situation in India—the world’s third largest consumer of crude oil—escalated into a grave humanitarian crisis.

The impact on oil demand will likely be greater than many analysts initially expected as supply chains are disrupted once again.

What about supply? That's clearer...

While expectations for oil demand swing from month to month, the direction of supply in the coming months is clear. It’s moving up. The Organization of the Petroleum Exporting Countries and its allies, known as OPEC+, have agreed to increase production this month.

Already in April, OPEC's oil production increased despite the organization's agreement to maintain production cuts during the month. Member compliance remained strong with cuts reaching 123% of the agreed level. However, production still increased because some OPEC members, including Iran, were exempt from the restrictions.

Despite U.S. sanctions, Iran managed to increase its exports of crude. Its production reached 2.5 million barrels per day in April, according to a Reuters survey. This was an increase of 200,000 barrels compared to March.

Bottom line

Crude oil prices rallied moderately in April as the economic outlook improved in several industrialized countries. Strong growth expected from the reopening of the U.S. economy has led many analysts to revise their expectations for global oil demand upward.

However, the COVID situation in India has deteriorated rapidly, which has blurred the outlook for the short and medium term. On the other hand, OPEC's oil supply already started to increase in April and will increase further in May with the partial lifting of production limits. Overall, price should hover in their current range for a little while.

Other economic indicators

Change of course at the Bank of Canada

As anticipated, Governor Macklem announced on April 21 that the Canadian monetary policy was going to be tightened by reducing the pace of the quantitative easing program. The Bank had been purchasing at least $4 billion per week in government bonds since the fall. It will now be $3 billion. Given the success of the vaccination campaign in Canada and the resilience of the economy since the second wave of COVID-19, the Bank of Canada improved the economic outlook in its most recent report. The report also highlights that the policy rate increase could be brought forward to the second half of 2022 rather than 2023.

Loonie soars to US$0.82

The Canadian dollar has held above US$0.80 for the past few weeks. The surge in commodity prices was largely responsible for the loonie's appreciation since the beginning of the year. More recently, the Bank of Canada's announcement to reduce its bond-buying program, ahead of all other major central banks, has propelled the loonie even higher. In just over ten days, the Canadian dollar has gained two cents against the U.S. dollar. In early May, it was above US$0.82, a nearly four-year high.

Third wave of COVID-19 dampens entrepreneurs' optimism in April

According to the most recent results of the Canadian Federation of Independent Business (CFIB) business survey, business confidence in the Canadian economy over the next 12 months declined slightly in April compared to March. The long-term index slipped by almost five points, but remains above 50 at 63.4. The short-term index, which measures the outlook over three months, remained fairly stable, sliding from 52.2 in March to 50.8 in April. This means that just as many entrepreneurs expect better results over the next three months as those who expect weaker performance. This CFIB report confirms that it is still difficult for businesses to see the light at the end of the tunnel. Accumulation of health restrictions seems to be outweighing the success of vaccination campaigns across the country.

Vaccination speeds up in the country

Vaccination is probably the best barometer of the economy these days. The economic recovery is limited by the restrictions imposed to fight the spread of the virus, not because of economic constraints (contrary to previous recessions).

Containment restrictions were lifted in most of the UK in April thanks to the success of the vaccination campaign. More than 50% of British adults are now vaccinated. The United States is close behind with 45% of the adult population vaccinated. Therefore, the U.S. economy is also expected to fully reopen by the end of June.

This is encouraging for the Canadian economy that is still fighting a 3rd wave of the virus and for businesses forced to close. Indeed, the good news is that vaccination has accelerated in the country and that access to vaccines has been expanded in several provinces. Although it will be a few months before we reach herd immunity, the economy could reopen in the next few weeks. For example, Saskatchewan has reached the first COVID-19 vaccination threshold laid out in its reopening plan and is ready to begin phase one of the plan. If the situations in the United States and the United Kingdom are any indication of what the future holds for Canada, business owners have every reason to be looking forward to it.

Key indicators—Canada

BDC MEL May 2021 key indicators Enlarge the table