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Monthly Economic Letter

April 2022
Feature article

Is the economy headed toward 1970s-style stagflation?

Stag-what? Stagflation. It’s an economic term that’s a mix of stagnation and inflation. It was coined in the late 1960s to describe a period of high inflation and low (or even negative) economic growth.

As we saw in the 1970s, stagflation is a nightmare for businesses and individuals. With inflation now at highs not seen for decades, there are growing fears that the U.S. and Canadian economies might be entering a new period of stagflation. Are these fears well-founded? What does future hold for the current bout of high inflation?

Indicators of stagflation

Of all the economic indicators, there are three that are of paramount importance: gross domestic product, the unemployment rate and inflation.

These indicators don’t usually bring good (or bad) news at the same time. For example, you don’t normally see low GDP growth and rising unemployment at the same time as high inflation.

When we talk about stagflation, it is because this holy trinity of economic indicators deviates from their usual relationship. We see low growth—even recession—and high unemployment along with high inflation. Is this what awaits North American economies?

Inflation rates on both sides of the Canada-U.S. border are disturbingly close to those that prevailed during the last period of stagflation in the 70s and 80s. Back then, inflation was public enemy No. 1, reaching just under 15% in the U.S.!

The dilemma for central banks was colossal as they were confronted by economies that needed stimulation to increase employment but also higher interest rates to calm price increases.

The precise source of stagflation remains a matter of debate among economists. However, the last two episodes—between 1974 and 1975 and 1978 and 1982—had some common elements. They occurred during an energy crisis and were preceded by periods of expansionary monetary policy.

So, are we there yet? Not quite.

In our time, the war in Ukraine has accentuated imbalances between supply and demand in the energy markets and pushed the price of crude oil up sharply. On the monetary side, governments and central banks have deployed extraordinary measures to support the economy through the COVID pandemic.

However, the decisive factor in stagflation is not directly linked to monetary policy, contrary to what many might believe. Instead, it depends above all on the expectations of households and businesses.

The risk of stagflation becomes more important as Canadians begin to expect inflation to remain higher for longer. The last Bank of Canada’s survey showed that many consumers were concern about inflation today but that longer-term expectations remained stable.

As long as households and businesses have confidence in the ability of the authorities to control rising prices and their expectations of future inflation remain anchored, this high-inflation period shall pass without too much damage to the economy.

The central banks’ wager

Monetary policy decisions are never simple. Even less so when you add such highly uncertain factors as a pandemic, the invasion of Ukraine and the economic war against Russia.

The central banks' bet is that tighter monetary conditions will calm demand and slow the current galloping inflation without causing a major slowdown of the economy. To do this, interest rates must rise and quickly, according to U.S. Federal Reserve officials.

However, it takes several months for rate hikes to fully work their way through the economy and this is why some observers are concerned about central banks tightening too much and throwing the economy into recession.

This is notably what happened during the last episodes of stagflation, which were marked by two deep recessions when the policy rate was increased to 18% in Canada and 20% in the United States.

Is there cause for concern?

While price increases will remain high for some time to come, by this time next year, we hope the supply of goods and services will have recovered from pandemic disruptions and interest rate hikes will have slowed demand. If these adjustments come to pass, we would expect inflation to return to more sustainable levels as early as 2023.

For now, the Canadian and U.S. economies are still on a solid footing. Yes, inflation is high and central banks need to address it, but unemployment is very low, and growth remains solid.

Businesses are struggling to keep up with strong demand, a sign that there is little or no excess capacity in the economy today. Economic growth should therefore be headed for a soft landing despite the high level of uncertainty we face.

The impact on your business

  • High inflation brings back painful memories of the stagflation of the 70s and 80s for many Canadians. But the economy remains on solid footing despite the high level of uncertainty.
  • The current inflation is mainly due to imbalances between supply and demand caused by the pandemic and the subsequent reopening of the economy. Inflation will remain higher than initially thought but should return to a more reasonable level in 2023.
  • Until then, price increases will remain high and interest rates will rise for quite some time, but households and businesses are in a good position to absorb much of these increases. As demand slows, supply will be better able to respond.
Canadian economy at a glance

Strong outlook despite sixth COVID wave

While the war in Ukraine brings uncertainties and challenges for the global economy, the main risk to the economic outlook remains the evolution of the COVID pandemic.

A national uptick in cases suggests Canada is heading for a sixth wave this spring. At this time, Quebec is the only province to have officially declared a sixth wave, but cases are increasing across the country.

Canadian vaccination rates are enviable and another round of health restrictions is not expected. The impact of this new wave on businesses and the economy should, therefore, be even less significant than previous waves. In fact, the economy has proven to be increasingly resilient with each new wave, despite health restrictions.

Nevertheless, we have learned, during those past two years of dealing with the pandemic, that a great deal of uncertainty accompanies this virus and its effects on the economy and businesses are very uneven from one sector to another.

Solid rebound in GDP following Omicron

Canadian GDP rose 0.2% in January, marking the eighth consecutive month of growth in economic activity.

The Canadian economy proved remarkably resilient in the face of the Omicron variant, which was the most virulent to date. Let's recall that in January, several provinces tightened health measures and forced the closure of many businesses. The country lost more than 200,000 jobs during the month.

According to Statistics Canada's preliminary estimates, real GDP rebounded strongly when the economy reopened in February, as did employment. GDP is estimated to have increased by 0.8% in February. The first quarter of 2022 should therefore have seen robust real growth of about 4.0% at an annualized rate.

The job market continues to tighten

After February’s strong rebound in employment (+336,000) generated by the easing of health measures and the reopening of businesses, the economy created 73,000 more jobs in March.

Growth continued in sectors most affected by the pandemic, namely accommodation and food services (+15,000) and information, culture and recreation (+4,000). However, activity in these sectors remains well below their pre-pandemic levels. Many employees have reoriented their careers as a result of the pandemic and there is still an important shortage of workers in these industries.

Labour shortages continue across the country and the number of job vacancies remain high despite strong increases in employment. In January, there were over 800,000 job openings in the country even if many businesses were closed because of Omicron.

The unemployment rate is down to a 48-year low of 5.3% in March.

With warmer weather on our doorstep and the summer season beginning, it’s expected tourism industries will be slowed by labour shortages. Activity in these sectors is labour intensive, so it will be more difficult for them to recover to their pre-pandemic level.

Accelerating the fight against inflation

Inflation is likely to have gained further momentum in March as a result of gasoline price increases. The price of oil was rising even before Russia’s invasion of Ukraine and has now increased by more than 20% since the beginning of the year.

Since the onset of the conflict, oil prices have varied widely from day to day, but have generally remained above US$100 per barrel, with the spot price of a barrel of crude trading 15% above its February average. As a result, we expect inflation in Canada to have approached, if not exceeded, 6.0% in March.

Central banks prefer to base monetary policy on less volatile measures of inflation than those that include gasoline prices. Nonetheless, supply chain problems are also causing price increases through the economy.

As a result, the Bank of Canada will continue its inflation-fighting efforts. Even though the level of uncertainty currently hanging over the economy is high due to the war in Ukraine and the rise in COVID infections, the bank raised its key rate by a half-percentage point on April 13, bringing it to 1.0%.

The impact on your business

  • Economic growth should remain strong despite the arrival of a sixth COVID wave. Households and businesses seem increasingly adept at navigating pandemic uncertainty with each new wave as evidenced by GDP growth despite Omicron.
  • The speed at which employment recovered in February and continued in March is a testament to fierce competition in the labour market. Make sure you have a hiring plan ready for the summer season, especially if you operate in tourism or other seasonal industries.
  • The demand for goods and services is not going away despite the growing uncertainty. This, combined with tight supply chains, is driving up prices. The Bank of Canada will continue its fight to bring inflation back into the target range (between 1% and 3%) with more rate hikes this year.
U.S. economy at a glance

Slower growth ahead as interest rates rise

As the Federal Reserve accelerates its fight against inflation, U.S. economic growth will slow but still remain positive for the foreseeable future.

Economic uncertainty has ratcheted ever higher in recent months, but despite this, the U.S. economy has maintained significant momentum. As we know, inflation has reached its highest level in 40 years, but so has GDP growth.

The consensus is for 3.3% growth in 2022 and 2.4% in 2023. The slower pace next year would still be above the average of the past 10 years and much more sustainable for the economy.

Consumer confidence still eroding

Despite the strong economy, consumer confidence continues to deteriorate in the United States. The University of Michigan's index fell another five points in March to 54.3, the lowest level in a decade. For several months now, pessimism about inflation has been outweighing the impact of a brightening pandemic picture on confidence. And the war in Ukraine will have accentuated household concerns.

Still, the University of Michigan index remains surprisingly low considering the country is in a period of economic growth. In fact, nearly one-third of U.S. consumers expect their financial situations to worsen over the next 12 months, the highest level recorded since the survey began in the early 1940s.

The U.S. economy is still experiencing solid momentum, even though inflation is weighing on household budgets. Growth is being sustained by significant savings accumulated during the pandemic and labour shortages that are pushing up wages.

Consumption is holding up well so far

Such high levels of pessimism usually dampen consumers’ appetite for higher-priced items, such as homes and automobiles. Declining purchasing power, dissipating pent-up demand and rising interest rates should also contribute to a slowdown in consumer spending in the coming months.

Adjusting for inflation, real consumer spending was down 0.4% in February as compared to January. In contrast, January's results were revised upward this month, recording growth of 2.1% (above the initial estimate of 1.5%).

So, for now, analysts believe consumption kept growing in the first quarter despite inflationary pressures, contributing to GDP growth early in the year.

Consumption of services increased by 0.6% while spending on goods slowed, probably signaling the beginning of a shift in spending towards services with the fading of the Omicron wave. The reallocation of household spending from goods to services should help support the Fed in its fight against inflation.

Federal Reserve to take a more aggressive approach

In his latest speech, Fed Chairman Jerome Powell showed more urgency to act in the face of runaway inflation than he had indicated just a month ago. Specifically, he opened the door to rate hikes of half a percentage point, double what we are used to seeing during tightening cycles of the past few years.

Still, financing conditions will remain favorable for investment because the tightening is starting from a low level.

A strong labour market

Despite challenges such as the war in Ukraine and continued uncertainty surrounding the pandemic and interest rate hikes, the U.S. economy added 431,000 jobs in March.

While this is a smaller increase than in each of the last six months, it was still a solid contribution to the 6.5 million jobs gained in just one year. However, employment still remains 1.6 million jobs short of its pre-pandemic level of February 2020.

The unemployment rate, meanwhile, fell to 3.6% from 3.8% between February and March. The rate is rapidly approaching its all-time low of 3.5%, reached in February 2020 before the pandemic hit.

A tightening labour market is starting to be reflected in wage gains. The average hourly wage increased by 5.6% over the past year and there are approximately 1.8 job openings for every unemployed person in the United States.

The impact for your business

  • Robust economic growth is still in the cards for the U.S., but it will be slower than last year as several headwinds intensify.
  • After an initial 0.25% increase in the policy rate in March, the Federal Reserve is expected to be more aggressive in future announcements. Interest rates in the U.S. will likely rise faster than in Canada this year. This should pull the loonie down later this year, providing further support Canadian exports to the U.S.
  • The strength of the labour market should continue to support consumption as more and more workers return to the job market and wages increase at a good pace.
Oil market update

Uncertainty will keep volatility high

Crude oil prices are yo-yoing—one week crude jumped 13%, only to fall 13% the next.

Brent and WTI prices, the leading global benchmarks, rose from around US$100 a barrel to $120 between March 17 and 25 before falling back to $100 on April 1.

Such jolts in the crude market could become increasingly common as long as the level of geopolitical uncertainty remains so high.

Russia at war while China continues to fight against COVID

Obviously, the main source of uncertainty comes from the war in Ukraine. The amount of crude and other energy products taken out of the market due to the conflict has the potential to significantly cut global supply, although this is still uncertain.

On the demand side, there are also concerns feeding into the high price volatility. Canada is not the only country experiencing another COVID wave. The number of new coronavirus infections is on the rise everywhere, including in China.

While the Canadian economy has become more resilient with each new wave, this is not the case for the Chinese industrial giant, which still maintains its policy of zero tolerance towards COVID.

Lockdowns have been imposed in many Chinese cities, including on the nearly 25 million inhabitants of Shanghai, the country's economic capital. An economic slowdown in the world's largest importer of crude oil will have inevitable consequences for the market in the coming weeks.

The U.S. draws on strategic reserve for the third time in six months

Meanwhile, the U.S. plans to add 180 million barrels, the equivalent of two days of global demand, to oil markets by tapping its strategic reserve at a rate of 1 million barrels per day for six months beginning in May. President Joe Biden is also providing strong incentives to U.S. oil producers, including owners of idle wells and unused leases, to increase production.

New supply from these sources will be more than enough to offset the losses caused by the U.S. ban on Russian oil imports. The strategic reserve announcement sent crude prices down 7% on the last day of March. U.S. allies may also boost supply.

This market intervention should provide some relief to consumers, but it’s a short-term measure, not a long-term solution.

OPEC ignores mounting pressure

For its part, OPEC and its allies including Russia have once again refused to ramp up production. Last summer, the organization's member countries agreed to increase production by an additional 400,000 barrels per day each month. At their most recent meeting in March, they only marginally revised this supply agreement, bumping it to 430,000 barrels for May.

However, OPEC+ was struggling to meet its targets even before the Russia-Ukraine conflict erupted. Pandemic-related underinvestment and to some extent the transition to low-carbon forms of energy explain why these countries are not able to produce at the agreed-upon rate.

Bottom line...

While the war in Ukraine is the biggest source of uncertainty affecting the crude market today, it’s far from the only one. There are uncertainty factors on both the demand and supply sides of the market, and these factors are not going away anytime soon.

The result? Prices are moving up and down from one day to the next with no clear direction dominating the other.

Both Brent and WTI have made significant highs in recent days but have also fallen back below US$100 a barrel more recently.

With so much volatility, it would be surprising if investment in the sector picks up quickly, so supply is likely to remain constrained in the longer term.

Other economic indicators

Bank of Canada picks up the pace

The Bank of Canada raised its key interest rate by a substantial half-percentage point on April 13, bringing the rate to 1.0%. Canada is therefore the first amongst the G7 countries to increase interest rate with a rare 50-basis-point hike. The resilience of the Canadian economy and labour market in the face of the last wave, Omicron, suggests that this sixth wave will not slow the bank's new tightening cycle in any way. The risk of inflation accelerating further due to the conflict in Ukraine and new lockdowns in China could instead accelerate future rate hikes.

The loonie hovers around US$ 0.80

After briefly surpassing the US$ 0.80 mark, the Canadian dollar was revised downward earlier this month. At the time of writing, the loonie was still at US$ 0.79 and is expected to continue to hover around this level throughout April. The USD/CAD pair will be influenced by the Bank of Canada's rate decision on April 13, which will be a few weeks ahead of the next announcement by the U.S. Federal Reserve. The interest rate differential should therefore favor the loonie against the greenback in the coming weeks before reversing in May. It is still expected that rates will rise more quickly in the U.S. thereafter. Oil market volatility and reduced risk appetite should keep the Canadian dollar below US$ 0.80 on average this year.

Business optimism continues in March

The Canadian Federation of Independent Business (CFIB) Business Barometer's long-term index kept its momentum, rising from 62.5 to 65.1 between February and March. This is the highest level reached since August 2021, a sign that the easing of restrictions is boosting business confidence across the country. The long-term index reflects the expectations of small and medium-sized business executives over a 12-month horizon.

However, the risk that the index will come down a bit next month due to the war in Ukraine and its impact, especially on input prices, remains.

Interest rates are rising

Interest rates had begun a modest climb this fall as the Bank of Canada ended its quantitative easing program and signaled the eminence of monetary policy tightening. Of course, rates have started to rise more rapidly since the first rate hike announcement on March 2. Effective interest rates for households and businesses have jumped by 0.45 percentage points since that first hike.

To curb inflation, the policy rate will continue to rise, and quickly in the coming months. Financing will remain affordable and favorable to investment for a long time to come, but it will still cost you more and more. Try to accelerate your investment projects or loan renewals sooner rather than later to save a little money.

Key indicators—Canada