The Bank of Canada’s effort to fight inflation is raising concerns about a possible recession. Greg Bonnell speaks with Andrew Kelvin, Chief Canada Strategist with TD Securities, about the state of the economy and the likelihood of a slowdown.
Great to have you with us, Andrew. I think this is-- I don't know what dollar value you want to ascribe to this question, but this is the big one for investors. For a lot of people, a lot of recession talk. What are the actual, real risks of a slowdown?
- I think they're material. I don't think we need to be worried about an imminent recession, per se, in terms of the month of June, which is behind us now, so July or even August. But I think if we can look into the first half of next year, we'll be in a position where the last lingering impacts of fiscal stimulus have likely worn off.
Interest rates will have been high for three quarters, essentially, and at that point, we do think there's a risk that the combination of lingering impacts from fiscal policy running off and high rates will really be biting into households. And right now, the thing that's driving the economy is household spending. If households feel they need to start pulling back on their discretionary consumption, in Q4 and Q1 next year, that is something that could potentially put the Canadian economy underwater, as it were.
Now, the one thing we do have as a tailwind is strong population growth. So we may wind up in a scenario where GDP growth-- usually, a recession's two negative quarters of GDP in a row. We may wind up in a scenario where the economy is technically growing, but it's only because we're adding more and more people. Which is going to feel like a recession for a lot of people, even if it doesn't technically meet that definition.
INTERVIEWER: Let's talk about consumer spending, because I'm really fascinated in the idea of a wealth effect. Right? That when your home value is on the rise, you're feeling wealthy. When your equity portfolio and investment portfolio is on the rise, you're feeling wealthy.
This is not the story of 2022. We're seeing a slowdown in housing. We've seen a sizable pullback in the first half of the trading year and the value of a lot of people's portfolios. Does that start to have an impact on how we feel about the economy going forward, our spending, and ultimately tipping us into a possible recession?
- I think it's part of the story, certainly, because if we're thinking about something that's going to be driven by over-tightening from central banks, housing is going to feel the brunt the most. Housing is probably the most interest rate-sensitive sector of the economy. And to your point, we talked about wealth effects. The housing market for Canadians in particular, it feels like the one number that rules them all-- it's the one thing that we can look at to gauge the healthy economy. When the housing market's screaming higher, even if the rest of the economy is just mediocre, a lot of times people will see that as a sign of robustness, in Canada.
If you look at the second quarter of 2022, it was really the opposite, because a lot of the other indicators we can look at for the strength of the economy-- unemployment rate is at multi-decade lows. But the housing market has really started to crumble. And it has really impacted consumer confidence. That's something you actually see in the consumer confidence data, which has been really sinking like a stone for several months now.
- If we did end up-- and obviously, it's not a fait accompli, a fancy word. But if we did end up in a recession, how does Canada fare compared to other G7 nations, or against the Americans? Would there be a reason that our economy would feel a little worse off?
ANDREW KELVIN: It really depends on the form of the recession, and it really depends on how widespread it is and what triggers it. A recession that's triggered by very, very high interest rates-- now, let's just say inflation is even more persistent than we expect. And the Bank of Canada needs to tighten more than we realize, and the Fed needs to tighten more than we realize. Because right now, markets are pricing in a move to about 3 and 1/2%, approximately, for both central banks.
If we need to get to 5%-- and I'm picking that number out of thin air-- but in that sort of a scenario, Canada would be hit quite a bit worse than the US, just given that we have very high levels of household leverage in this country, which is a double-edged sword. The fact that Canadian households are so leveraged is one of the reasons why in downturns we tend to get a really quick response from interest rate cuts. The Bank of Canada cuts rates. People go out and spend more money, buy houses, et cetera, et cetera, and Canada has, in recent cycles, had relatively shallow downturns. I go back to the financial crisis or the period right after that, as an example.
The flip side to that is, if we wind up with very, very high interest rates, Canada will get hurt more than our neighbors to the south. On the other hand, if you want to look at other supply shocks, things like another significant leg higher in oil prices-- I know they're falling dramatically today. But if you want to come with a scenario where high energy prices cause slowdowns in Europe, and that trickles into the rest of the world, Canada's relatively well, compared to our neighbors, just because we do have that commodity component to our economy.
Now, if I'm going to look at the most likely thing that causes a global downturn, it is going to be higher interest rates, triggered by high inflation, and Canada probably is a bit more at risk. Though, I would add, there's a feedback loop here. If Canada has larger negative impacts from high rates than the United States, it stands to reason, the Bank of Canada will probably tighten less than the Federal Reserve in that sort of scenario.
INTERVIEWER: Let's talk about the role central banks are playing in all of this. Of course, we have a Bank of Canada decision next week. We had the business outlook survey land this week and the consumer survey. And whether you're talking to a business owner, you're talking to a household, they expect inflation to be around for a while. It seems to be opening the door to the 75 basis rate hike again. These super-sized rate hikes, I don't feel like anyone saw them coming. How long is this going to persist?
ANDREW KELVIN: It's amazing how quickly the conversation has shifted on what is not even possible or plausible, but just-- well, possible, I should say. Because if you had told me in March that I was going to be discussing 75 basis point rate hikes by July, I would have laughed and walked out of the room. It just didn't seem plausible.
- Drop the mic, and on you go.
ANDREW KELVIN: And I say that, even in March, when it was clear that the Bank of Canada was behind the curve. Right? Because a lot of people had been looking for the bank to lift rates in January. They decided not to. I think that was obviously something they would like to take back, in hindsight.
But even if they'd lifted rates by 25 basis points in January, I think we still would have been taken aback by how strong this inflationary impulse has been, how broad it's been. I think that's really been the thing that the bank didn't anticipate, that a lot of forecasters didn't anticipate. One of the things I have been saying recently is I think, if you're looking for inflation advice, you probably did better talking to Main Street over the last six to eight months than you did talking to Bay Street, bluntly.
It's a scenario where you now have had transitory factors persist for over a year, and people no longer believe they're transitory. It unanchors inflation expectations. That's what we saw in that business outlook survey that came out yesterday, and that was the thing that we think had really spooked the Bank of Canada, once you got to June 1 and 2, is they would have seen the early results of that, potentially.
If inflation expectations become unanchored, that's something where they really need to act robustly to show their credibility. And if they don't lift rates by 75 basis points next week, and our expectation is there will be a 75 basis point move, anything less than that I think is going to raise serious questions about how willing they are to take the difficult decisions necessary to tame inflation. Which, ultimately, all that ever does is push pain down the road. So as much as the robust interest rate hikes are going to prove painful for the economy, the alternative is potentially much worse.
- One of the things that investors are looking at now, amid all the things we've already talked about, is any sign that perhaps that inflation has peaked. You mentioned the fact that the central banks really didn't have a clear view of where we'd end up in this current inflationary environment. Transitory was used so many times, before they retired it. Where should we be looking now for any signs that inflation has peaked or maybe will peak in the near future?
- So I think people have called probably several peaks over the last year in inflation. So I'm not going to call a peak today. I'm not going to tell you when inflation will peak, because I'm actually not even sure that's a helpful way of thinking about it this point. If energy prices are off their peaks, if the move we see today in energy prices proves sustained-- and energy prices have been very volatile, so I'm not going to bet one way or the other on one day's move in energy prices-- that will take the edge off inflation somewhat.
I think the key thing here is, because the inflation we're seeing is so broad, it's not just hotels and gasoline. It's really broadly spread across the economy. That sort of inflation tends to persist for longer.
So even if we are near the peak, the slowdown inflation will be more gradual than what we've seen in past cycles, because it's not just one or two things driving this. It is a broad inflationary impulse, supported by a very tight labor market. Because one thing we saw in that business outlook survey yesterday was, the expected wage increases that businesses are budgeting is at record highs, and that tends to be something that perpetuates inflation through time.