Highlights
- Elevated policy rates and tight financial condition continue to slow consumer spending in Canada, the euro area and the UK.
- We don’t see the BoC, the ECB or the BoE hiking rates further. Inflation readings in these regions remain above target but are set to drop further as excess demand in the economy dissipates.
- The U.S. Fed is also expected to forego additional rate hikes despite an acceleration in Q3 GDP growth. Muted inflation pressures and cooling labour markets are leaving the Fed room on the sidelines.
- Evidence mounting that economic activity is softening and that inflation will continue to slow. Central banks are willing to step in again to bring inflation under control. But additional interest rate hikes look increasingly less likely – particularly in Canada where key indicators like per-capita GDP, and the unemployment rate are already tracking closely to early stages of historical recessions.
Against an over-heating economic backdrop, even good data can be bad news. Persistent upside surprises on the US economy, including a blockbuster reading for Q3 GDP growth reinforced the view that it might take a longer period of restrictive monetary policy to get inflation in the US sustainably back under control – delaying but not preventing a slowdown in the economy. Interest rates on US government bonds increased throughout October alongside a rise in term premiums, and steeper yield curve.
That was until last week, when Fed’s decision to hold key rates steady for a second time in a row sent markets rallying. The gains were then extended by a softer-than-expected employment report later in the week. 10-year treasury yield dropped sharply over the week, and the yield curve flattened, reversing some of the steepening earlier in fall.
The outlook elsewhere is gloomier. GDP growth in the euro area contracted slightly in Q3 and conditions in the UK looks on track for a similar sized decline in the same quarter. There are growing signs that the Canadian economy is buckling under the weight of higher interest rates and prices. The U.S. dollar held on to broadly based appreciation over the last month, while CAD underperformed as the economic backdrop softens ahead of the other economies.
Inflation readings are still high in Canada, euro area and the U.K., but are on balance moderating. Central banks will remain ultra-cautious about taking their feet off the economy’s brakes too quickly. But softer economic growth numbers today mean slower inflation tomorrow and should reinforce expectations that central banks are done hiking interest rates for this cycle. We expect most central banks (with the RBA one notable exception) to hold rates steady before pivoting to gradual cuts starting with the Fed in the second quarter of 2024.
Current Policy Rate
(Latest Move)
BoC
The BoC again left the overnight rate unchanged at 5% in October, amid more signs of softening economic growth (GDP’s tracking another small quarterly decline in Q3) and slowing hiring activities. We continue to look for weaker demand to slow inflation, keeping the BoC on hold in the current cycle.
Fed
5.25-5.50%
+0 bps in Nov-23
After two skips in the interest rate decisions, the Fed now looks to be officially on hold. The press release accompanying the November announcement highlighted strong economic growth but also significantly tighter financial conditions. Labour demand is cooling, and inflation readings remained muted overall. We don’t see the Fed moving rates any higher in the current cycle.
BoE
Inflation in the U.K., especially in the closely watched services components, remained elevated in September. Still, weaker services activities according to the PMIs and ongoing deterioration in labour market conditions all suggest that domestic price pressures should keep receding. We see the BoE holding the Bank Rate steady from this point forward, at 5.25% through 2024.
ECB
The ECB in October left the deposit rate unchanged and noted “striking” evidence of the “forceful” transmission of monetary policy. Bank lending for both mortgage and corporate loans kept pulling back. Survey data has also continued to point to contractions in output. We don’t see the ECB moving rates higher and expect the 4% deposit rate to be held through 2024.
RBA
An upside surprise in the Q3 inflation report promoted the RBA in November to move the cash rate up by 25bps, to 4.25% currently. Hurdles against another rate hike in the near-term are still very high. But tangible risks of an extended inflation overshoot also remain. We expect the RBA to pause in December, before taking the cash rate higher by another 25bps to the terminal of 4.60%.
Excess demand disappearing in Canada as spending slows
Evidence continues to build that the Canadian economy is losing steam. Early estimates from Statistics Canada are pointing to a (second consecutive) small decline in Q3 GDP – led by a pull-back in consumer-sensitive sectors like retail and restaurant sales, as well as lower manufacturing output. Taking into account surging population growth, GDP per-capita looks on track to decline a similar amount in Q3 as the 3 ½% annualized drop in Q2, marking a fifth straight quarterly drop.
Employment has continued to rise, but not fast enough to prevent a significant 0.7 percentage point rise in the unemployment rate to 5.7% in October from 5.0% in April. Growth in wages has yet to moderate persistently but businesses expect pay increases to slow in the year ahead, according to the Bank of Canada’s own Business Outlook Survey for Q3.
Indeed, the BoC estimated that the economy-wide output gap (the gap between the current level of GDP and the level that would be consistent with the target 2% inflation rate) is already much closer to zero. Inflation readings are still running above target but will slow as the economic backdrop softens. Our own CPI diffusion index suggests the breadth of price pressures is still wide, but are showing improvements – a growing share of consumer basket is starting to see mid-range (3% – 5%) instead of very high (5%+) inflation readings, with close to 20% of the basket seeing outright declines in prices on a 3-month annualized basis.
Absent a larger pick-up in inflation readings and with GDP growth still expected to trend below the “potential” rate for some time, we see little prospects for the Bank of Canada to move the overnight rate higher again and expect them to start cutting in the second half of next year.
Being mindful of the downside: Canadian households are vulnerable to softer labour markets
Key macro indicators are suggesting that the Canadian economy is in the early stage of a “mild” contraction. The rise in the unemployment rate to-date has been driven by slower hiring rather than outright layoffs. Still, that is typically what the early stage of a labour market slowdown looks like – with average hours worked declining before employment counts. Canadian GDP on a per-capita basis and the unemployment rate are also tracking a path consistent with, but on the ‘mild’ range, of early-stage economic contractions historically.
Still, risks remain that conditions could get worse. Household spending remained resilient through more than a year of aggressive interest rate increases and high inflation. But household debt servicing costs are already at record highs. Remaining pandemic savings are concentrated at the top end of the income distribution and have shifted into term deposits that are less likely to be spent in the near-term. And the impact of interest rate increases to-date have yet to fully pass through to household effective debt payments. The risk that a ‘mild’ economic slowdown could yet turn into something worse should only reinforce that the Bank of Canada is done hiking interest rates for this cycle.
Growth momentum in the U.S. still strong but not expected to persist
A resilient U.S. economy over the summer was largely overlooked when the Federal Reserve decided to hold the fed funds target range at 5.25% -5% for a second meeting in a row in November (and the third in the last four that the central bank opted to forego a hike.)
Consumer spending has been incredibly resilient, accelerating in Q3 despite higher interest rates and still elevated prices. But robust consumption has been financed in part via households spending more out of their current income than they used to, and accumulating less savings. That is not expected to persist, especially when the household income growth backdrop is getting murkier as labour market conditions deteriorate. Employment growth has remained relatively firm. But wage growth has slowed persistently. The 0.4 percentage point increase in the US unemployment rate over a 3-month period is also rare and has usually only happened at the start of a labour market downturn.
Fed officials remain concerned about inflation. Moving forward a dimming economic and labour market outlook should continue keep a lid on price increases, in part balancing out risks of easing financial conditions as yield curve will likely give back more of the aggressive steepening over the recent months. We don’t see the Fed hiking more this year and expect them to start gradually moving key rates lower in the second quarter of 2024.
Softer service activities keeping the ECB and BoE on the sidelines
Elsewhere in euro area and the UK, softening trends in economic growth are persisting. GDP contracted slightly in Q3 in the euro area, and we look for a similar sized decline in output for the UK over the same quarter (-0.2%). Early PMI data for October suggests the softness was carried over to Q4. Indeed, cooling goods demand has been putting downward pressure on manufacturing activities in these regions since mid-2022.
Activity in the service sector has been more resilient, but that momentum is also starting to wane over the past months with the PMI service sub-index dipping below the no-change 50 mark. Softening activity across sectors is also starting to feed through to slower labour market conditions. The unemployment rate has already started to creep higher in the UK and should start to very soon in the euro area, as hiring demand cools.
The good news is that slower demand should allow inflation to keep slowing and reduce pressure on central banks to push interest rates higher. The ECB and the BoE both held key interest rates steady in their latest meetings over the past two weeks. Similar to Canada, a deteriorating macroeconomic backdrop coupled with signs of softening labour market conditions in these regions suggest that inflation will more likely continue to moderate rather than reaccelerate. We expect both the ECB and the BoE will hold rates at currently high levels through 2024, after which they will pivot to cutes at a gradual pace.
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