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Monthly Economic Letter

July 2022
Feature article

Rising interest rates: When will it end?

Between runaway inflation and rapidly rising interest rates, cost pressures have been mounting for consumers and businesses in Canada. These are conditions Canadians have not been experienced in a long time and the impact can be felt from real estate to financial markets to everyday prices and wages. The era of cheap money is over, but how high will rates go? It all depends on inflation.

Inflation to break new records this summer

Inflation has been accelerating since the reopening of economies around the world from COVID lockdowns. It’s causing an inflationary shock that is stretching longer than expected, fueled by persistent supply chain disruptions and the war in Ukraine.

The good news is that the inflation picture should get better with time. Supply chains are showing encouraging signs of improvement as businesses diversify their suppliers. And while the war and accompanying sanctions on Russia are still hampering several commodity markets—notably food and energy—the worst of the initial shock appears to be behind us.

On the other side of the coin, price increases will remain substantially higher than those observed a year earlier for several more months.

Shortages have led companies to massively boost inventories with many businesses moving from "just-in-time" inventory management to "just-in-case." As they try to meet high demand and build inventories, they are contributing to further clogging of transportation networks.

Oil prices are pushing prices higher

High oil prices are also contributing to inflation as global crude supply struggles to meet demand. Obviously, surging oil prices are being felt by motorists at the pump, but they are also having significant spillover effects elsewhere in the economy. For example, energy is a major input in commodity production and distribution.

While businesses are passing on cost increases to consumers, Canadian households remain resilient, at least for the time being. According to a recent BDC survey, 25% of Canadians have not changed their spending habits because of inflation and the rest say they’re more likely to search for bargains than to restrict their purchases.

We believe it will likely take until the beginning of the new year before inflation falls below 5% and until the spring of 2023 before it returns to the Bank of Canada's target range of between 1% and 3%. That said, while inflation will continue to break records in Canada over the summer, we don’t expect to hit double digits.

No choice but to hike rates

Faced with high levels of inflation and tight labour markets, central banks have no choice but to act aggressively.

Clearly, the Bank of Canada is determined to do what it takes to achieve relative price stability as evidenced by the latest 100 basis-point hike in its policy rate. That hike brought interest rates closer to what economists consider a neutral rate—one that neither stimulates the economy nor holds it back. However, monetary policy will likely need to move above the neutral rate for some time to allow supply and demand to rebalance and for the risk of high inflation to recede.

A period of unusually low rates

In 2008-2009, central banks around the world adopted extremely low interest rates in response to the financial crisis. The U.S. Federal Reserve lowered its key interest rate to 0% in December 2008 in an effort to stimulate the economy. It kept it at that level until December 2015 when it began to modestly raise the rate until it reversed the trend once again in response to the pandemic.

In the face of the financial crisis, the Bank of Canada lowered its rate to 0.25% in June 2010. Economic conditions allowed it to keep the policy rate at 1% until January 2015 when it had to be lowered again in response to plummeting oil prices.

This long period of abnormally low rates lasted so long that it seems to have become firmly entrenched in the expectations of Canadians for where rates should be, even when the economy is strong.

We believe household and government indebtedness is high enough that the policy rate should peak at 3% to 4% in Canada. The most recent Bank of Canada announcement on July 13 brings it to 2.5% and we now expect it will reach 3% by the end of the year. This will still be low by historical standards, just not what we had come to expect during the recent period of ultra-low rates.

While the interest rate environment in the coming years will look different than what we’ve seen in recent years, this is not bad news. The risks of sustained inflation remain high. Despite the discomfort of rapid rate increases, they’re necessary for the economy to return to a healthy and sustainable pace of growth.

Canadian economy at a glance

Headwinds are rising, but the Canadian economy continues to perform

An energy shock, a slowing real estate market, falling stock prices, inflation, rising interest rates—it all adds up to an increasing risk of recession in Canada. While we do expect economic activity to slow down in the face of these headwinds, we are not talking about a recession this year.

Has GDP already started to decline?

Economic activity in Canada continued to expand in April with monthly growth of 0.3%. However, according to Statistics Canada's first estimates, the economy contracted in May by -0.2%.

This anticipated slowdown would have mainly been in the mining, oil and gas, manufacturing and construction sectors. However, Statistics Canada’s preliminary estimates, which have only been published since the start of the pandemic, tend to underestimate the final results.

The Bank of Canada has not been deterred by this anticipated downturn, as evidenced by a significant 100 basis-point increase in its policy rate announced on July 13. Inflation hit a new 40-year high in May at 7.7%, another sign the economy is still running too hot.

Still room for growth

Despite the rate hikes to combat Canada's spiralling inflation, businesses continue to see strong demand.

Demand is being supported by a still buoyant job market in the country that continues to drive household spending. Workers are taking advantage of a tight labour market, with over one million job vacancies in the country as of April and an unemployment rate at 4.9% a new record low. The situation is increasingly reflected in wage gains (+5.2% in one year).

The increase in incomes combined with the still significant savings put aside during the pandemic are softening the blow of inflation for many households.

Supply chains improving, but risks remain

After months of dealing with unpredictable delivery times and persistent shortages, business leaders are finally seeing the first signs of improvement in supply chains. China continues to ease its harsh COVID lockdowns and container prices have begun to descend, a sign that container supply and demand is quietly rebalancing.

The situation is improving, but it’s still too early to claim victory since several factors are likely to aggravate the situation once again. The leading threat is China insistence on maintaining a zero-tolerance policy towards COVID outbreaks. A large part of its population is still not adequately vaccinated.

The housing market hits a speed bump

Rising interest rates are already impacting the housing sector. Home sales were down 9% in May compared to April and overall real estate sector output in April was down 0.8%. That’s the second straight monthly decline and the worst result for the industry since April 2020.

The housing sector represents about 13% of the economy and this poor performance subtracted 0.1% from GDP. With the Bank of Canada raising rates sharply, activity in the sector is expected to continue to falter in the coming months.

Rate hikes are also hurting the financial sector. As capital markets cool, the sector lost 0.7% of its GDP from March.

What does this mean for your business?

  • Households remain well-positioned to support the economy through the current turbulence. A strong labour market, rising wages and accumulated savings will continue to support demand.
  • Interest-rate hikes are cooling the housing and stock markets, but the latter are coming down from too high a level. Activity in the hardest hit sectors will continue to slow in the coming months, but we don’t foresee a crash.
  • Despite signs of improvement, supply chains remain a major challenge for entrepreneurs. If this is your case, diversify your suppliers and find out what support programs are available to help you deal with the problem.
U.S. economy at a glance

Increasing concerns about U.S. growth prospects

The Federal Reserve raised its rate by three-quarters of a percentage point in mid-June, the largest increase since 1994. In an attempt to control high inflation, the Fed has now increased the overnight rate to a range of 1.5% to 1.75.

The Fed is not done raising rates despite a darkening growth outlook for the U.S. economy. According to the Atlanta Fed's model forecast, real GDP would have declined by 2.1% in the second quarter. Considering that GDP growth had already turned negative in the first quarter of 2022, these estimates suggest that the U.S. entered a technical recession in the first half of the year.

Labour market remains solid

The job market continues to thrive despite the slowdown. The country added 372 thousand new jobs during the month of June and the unemployment rate remains at a historically low level (3.6%).

Wall Street's woes may begin to be reflected in the U.S. labour market this summer. In addition to the dire situation in the crypto-currency industry, many tech giants have announced hiring freezes and even downsizing.

Consumers cut back on spending

Runaway inflation has finally caught up with consumers’ will to spend. In addition to a 0.4% decline in real consumer spending in May, the first four months of 2022 have also been revised downward.

The decline in vehicle purchases was particularly large in May (-8.2% compared to April). Motor vehicles and parts account for about 4% of total U.S. consumer spending. Obviously, rising prices and financing costs are limiting Americans' vehicle purchasing power, but the country is also still struggling with vehicle shortages. It's hard to buy a car that doesn't exist...

Fear of darker days ahead pushes up savings

Consumer confidence has been low for several months now, abnormally low considering that the economy was still expanding during the last few quarters. Inflation had a lot to do with it, and now that the stock market is on a downward trend, we don't expect optimism to return to the U.S. anytime soon.

The good news for the U.S. economy is that corporate earnings continue to rise, despite a climate of pessimism that is setting in among businesses. Meanwhile, household incomes rose by 0.5% in May, largely due to a further 0.5% increase in wages compared to April.

Consumer pessimism about the future, coupled with income increases, is translating into increased savings. The savings rate rose from 5.2% to 5.4% between April and May, the first monthly increase since the beginning of the year.

More Americans are putting off buying a home

Just like the Canadian real estate market, interest rate hikes are also having an impact on the residential market south of the border. However, the situation is a little different in the United States. While sales of existing homes are falling—reaching a two-year low in May—the median price reached a new high.

According to the National Association of Realtors’ report, properties listed for sale remain on the market for just 16 days on average. Thus, the U.S. market still seems very hot. Housing supply is insufficient and still can’t meet demand despite interest rate hikes. The only encouraging sign for first-time buyers comes from the price decreases posted in certain previously hot large markets.

A reversal in inventory levels and sales is expected to become more apparent in the months ahead against the backdrop of aggressive interest rate hikes by the Federal Reserve.

The impact for your business

  • The U.S. economy is slowing and challenges are increasing. However, employment continues to thrive and incomes are rising, which is encouraging for demand and consumption.
  • Pessimism and uncertainty are on the rise around the world, which favours safe havens such as the U.S. dollar. In this context, the exchange rate between our two countries will continue to favour Canadian exports.
  • Households are becoming increasingly anxious about the economy and are beginning to save more and consume less. If you deal with U.S. customers, you may experience a lull in orders over the next few months.
Oil market update

Oil supply is tight and will probably get tighter

The price of a barrel of Brent crude averaged US$117 in June while WTI averaged US$115. Recession fears have been growing around the globe for the past few months, but those concerns have not been reflected in the oil market until now.

Despite a struggling stock market and a rising U.S. dollar, which is notorious for its inverse relationship with crude prices, oil continued to trade above US$100 per barrel in June and risks are they will go back up again. The cause? Weak supply.

"Force majeure" on Libyan crude exports

Instability in Libya is forcing its major oil terminals to declare force majeure on their crude oil shipments. A force majeure clause excuses non-performance of contractual obligations in whole or in part. The closures of the country's ports and major oil facilities is removing supply from an already tight global oil market.

Libya’s exports are down by about two-thirds from a year ago. Its exports were reported to be between 365,000 and 410,000 barrels per day in June, down from an average of 1.1 million barrels per day in 2021.

OPEC+ misses its target…again

It’s no surprise that the Organization of the Petroleum Exporting Countries and its allies (OPEC+) has failed to increase production target in June since it hasn’t met its target for several months now. According to Bloomberg, production even fell by 120,000 barrels per day in June, despite the fact that the countries had agreed to raise their quotas that month.

Among OPEC's allies is Russia, whose exports are under pressure from an embargo by the U.S. and the start of a European Union plan to slash imports. Libya is also an OPEC+ member and contrary to expectations, Saudi Arabia failed to make up for Libya's losses. In fact, the Saudis missed their quota by 213,000 b/d.

In such a context, it was surprising to see OPEC+ recently commit to raising production even further for August (+648,000 b/d).

Uncertainty rises in the North

Norway produces about 2 million barrels per day. While from a global perspective this may not seem like much, in the current oil and gas supply situation, a strike by 8,250 Norwegian industry workers would create even more tightness in the market.

Despite reaching a tentative agreement earlier in June, employees declared a strike for July 5. The Norwegian government has intervened to halt the strike by oil and gas workers. According to Reuters, an extended strike would reduce the country's oil production by about 8% and its gas production by 10%, which could have push global prices even higher.

Bottom line…

As recession fears grow globally, oil and gas prices began to trade lower albeit still high. Supply problems are piling up around the globe and are still outstripping concerns about the impact on demand of an economic slowdown for now.

Falling production in Libya, restrictions on Russian exports and losses from a strike in Norway are unlikely to be offset by OPEC+, which continues to miss its production targets month after month.

Other economic indicators

Inflation at 2% and nothing else

Inflation is not going anywhere in Canada, but the Bank of Canada is determined to bring it back to its 2% target. That is why the Bank of Canada raised its policy rate by an additional 100 basis points on July 13 to 2.5%, even though signs of an economic slowdown are increasing. At the current pace, the policy rate is expected to reach 3.0% before the end of the year. (Read more about interest rates and inflation.)

Canadian dollar falls on economic uncertainty

The loonie has begun to slide in early July. Fears of a global recession are gaining momentum, which favours the U.S. dollar against the Canadian currency. These fears are also causing a downward revision in crude oil prices. Although the relationship between oil prices and the loonie is not as strong as it once was, crude oil prices still influence the value of the Canadian dollar.

In June, oil was trading around US$115 per barrel and the Canadian dollar was averaging 78 cents U.S. Since then, oil has been revised downward closer to US$100 per barrel and the loonie at 77 cents. The loonie is expected to hover around US$0.76-0.79 this summer.

Pessimism is increasingly taking hold of entrepreneurs

Although business is still very busy, more business leaders are worried about the future than in May. In June, the Canadian Federation of Independent Business (CFIB) Business Barometer's long-term index fell by two and a half points, following May's three-point decline.

All in all, these results are not too worrisome and are similar to the confidence levels that prevailed prior to the pandemic. As such, a majority of business leaders remain optimistic about the future.

Key indicators—Canada