Beata Caranci: Inflation outlook improving, but not tamed yet

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* If recent economic data is anything to go by, it appears that so-called sticky inflation may finally be getting unstuck, and that, along with slowing employment growth and softer consumer demand, is fueling speculation. The Fed may now be looking at rate cuts next year. Here to help us navigate the next few months and beyond is Beata Caranci, Chief Economist at TD, and one of my favorite people. I'm just saying that. I always enjoy our conversations. Has inflation been tamed?

* So that's a good word, "tamed," because what's coming to mind is that movie. I think it was Black Stallion. I'm getting a flash from the past from my childhood. And that's where there was like this wild horse and this boy stranded on an island, and to tame or befriend the horse, he gives them seaweed.

* Yeah.

* And then over time, it works, and he actually tames the horse. I feel like we're in the seaweed-feeding stage right now on inflation.

* Does the Bank of Canada like seaweed? I don't know.

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* No, I think they're basically saying, we're making progress and we're building trust in each other and trust in the inflation metrics that they're decelerating, but we're not at the tamed stage. Because if you look at core inflation metrics, they are about 3.5% on the Canadian side. US core CPI is about 4%. So neither bank has won the battle, but these are still metrics that are down several percentage points from their peak levels. But they're not at 2%.

* Yeah.

* They're not even cracking below the 3% barrier yet, and we think that'll happen in the second half of next year. So there's still a ways to go to tame inflation, but it's certainly moving in the right direction.

* I was listening to some folks and they talked about the fact that the shelter costs, being a component of core, it's almost like a circular error on Excel, because high mortgage rates contribute to that, which is controlled by the Bank of Canada. So if you back that out, is inflation a little more tolerable?

* Very much more tolerable, but unfortunately, shelter is a large part of people's household budgets. And it's not just the mortgage interest costs. It's also rental costs that are accelerating. And then we've got to be careful what we exclude because there's other factors happening. If you look at what people are spending in health care services, those are also rising. Maintenance of vehicles are extremely high still. So there's a lot of different components. What the Bank of Canada generally does is they look for the breadth of the deceleration, and so that's why they wouldn't just focus on one.

* So do you mean that everything is actually decelerating?

* Yeah. Things are decelerating, but a number of them are still in that 4% to 6% range, although they're a smaller group of them. And so they're going to continue to focus on the aggregate versus that single measure.

* What about the labor market? Because I was speaking with someone last week and they talked about labor hoarding, how some companies are kind of hanging on to people because maybe they don't want to have to go through that cycle of laying off and rehiring and stuff. Is that part of the resilience maybe we're seeing in the markets, or is it other factors? Are we even seeing that?

* Well, that's part of every cycle, because that's why the labor market is a lagging indicator. What we have seen at the Bank of Canada surveys is many companies now saying they're not having an issue on finding labor and that they have much lower hiring intentions. So that's a little bit of a red flag, and those numbers are quite low, in terms of the percentage of firms who plan to do hiring. You're, in some cases, at levels that are a precursor to a recession. In some cases, it's not. It's a precursor to a very slow cycle. So hence the debate that continues to rage on. So I think that's still ongoing.

* In Canada, one of the less favorable trends that has happened recently is the private sector is scaling back jobs. And so when you look at the three-month moving average, you actually have job losses happening in the private sector, and those are in a number of sectors. Like the finance sector is an example. The construction sector is another, even the manufacturing sector. And so we have to be a little bit cautious that there are other signals starting to come through. We are not seeing that in the US. US private sector hiring is still well above trend, averaging about 150,000 a month, which is terrific for them, but very diverging trends on the Canadian side.

* The next question, I think, is probably connected to, I guess, your outlook and whether it is a recession coming or whether it's a soft landing in the markets. Equity markets are pricing in perfection, the soft landing that things will be coming. And a lot of market watchers have been also talking about the fact, you could see a 200-point basis cut next year as banks try and stimulate when they need to. So what are you expecting to see, I guess, both from an economic outlook and central bank action next year?

* Yeah. So from a central bank action, markets are priced in about 100 basis points in cuts for both the US and in Canada. That's actually been quite a big shift. There's been nothing priced just like a week ago. So it is moving on those expectations, and under the belief not necessarily the soft landing, that inflation is getting under control, because we got the inflation numbers just a week ago that were quite terrific, in terms of the trend. In terms of the economic outlook, we're sort of bearish on Canada. We only have about 0.5% growth next year, which leaves zero room for error.

* So we're definitely sitting on the fence of whether Canada could avoid a recession. It certainly can avoid a deep recession. We're sitting on the fence of whether it's an economy that just moves sideways or has a shallow recession. We do have an expectation that the unemployment rate will keep rising. In the US, we have almost three times the growth, so it's over 1%. It's still slow in terms of US perspective, but that's going to be one of the strongest economies of the advanced economies. They already are, and we think they're going to maintain that divergence, but maybe narrowing the gap to the relative outperformance of this year, which they were right out of the gates this year.

* I want to squeeze this one in, just because you're comparing the US and Canada, but what's the difference? We have this huge population growth. We have people coming in. Why are we see that divergence in growth paths?

* I think the fact that Canada is much more interest rate-sensitive, because the transmission of interest rates come through the mortgage market and renewals very quickly in Canada, just because of the structure of renewing often on a five-year cycle. And in the US, they lock in often on a 30-year cycle. And so they have been insulated, for the most part, on the rise in interest rates. And they also had a starting point of much higher levels of excess savings than we had in Canada, in part because the government was handing out checks, irrespective of your employment prospects from the pandemic. And so everybody, it was like this rising tide--

* You get a check and you get a check.

* --that lifted all ships. Yeah, exactly. And then what they did in the US is a lot of refinancing activity occurred in 2020 and 2021 when the policy rate was at 0. And so people ended up with a lot of savings and not having to pay into their mortgage, and so it gave them this double boost on the savings side. So they've been running that off, but it's allowed consumer spending to be a lot stronger there than what we've seen in Canada, on top of the fact that they don't have the interest rate sensitivity that we do here.

* You mentioned that the US had a renewal cycle earlier, in a few years, maybe before Canada has. And we're now beholden perhaps to higher mortgage rates and what that means. So what is that going to mean for Canada's housing market? It's corrected. Do you see more coming?

* Yeah. I think there's still a little bit more to come, especially because our forecast includes a flat to down labor market over at least the next six months, but likely a bit longer. And so from that perspective, we had about a 5% drop in prices between now and early first quarter-ish next year, and we did deepen that to 10%.

* Now, for different reasons, it's not just a labor market story. Really, it's a story that we've seen supply adjust much faster than we were expecting. So our forecast on decline in sales is actually holding intact, and what's not holding intact is that supply has gone up about 30% since May.

* Wow.

* And that was quite striking that we just saw this big dump come through into the market. And it was really unique to Ontario-- BC as well, but really Ontario. And that pushed the province immediately into a buyer's market. So it went from balance to buyer in a very short period.

Multi-units are coming on more so than existing single detached homes, but it has been a big shift. And so we have to take that on board, that there is supply sitting, coming on constantly and not getting absorbed, in addition to buyers themselves moving to the sidelines. And a big change at that time, why May till now, was when the central bank started to re-hike.

* Yeah.

* And so it looks like they found that point of inflection. That extra 50 basis points just shot everybody off to the sidelines.

* It's fascinating, too, when you think about the profile, and you would know better than me. But I'm wondering, these are investment buyers who are much more sensitive versus someone who's living-- and who knows? We'll find out over time. What is your thought, given Canada's economic trajectory next year, for the Loonie?

* Because we think Canada will be the weaker of the two economies between Canada and the US, we do think that the Loonie still has a little bit of downside. And the reason is because we think the Bank of Canada will be in a position to cut earlier than the Fed, potentially by a full quarter. I know a lot of people often say, oh, the Bank of Canada follows the Federal Reserve. That's not true.

* They do march to their own beat, and I think they'll be cutting around starting in the second quarter. We think they're not going to be aggressive because they're going to be very cautious of the inflation cycle and re-stoking that, especially with housing demand and immigration levels always being this pop-up every time you take pressure off, and it comes up really quickly. So they'll be cautious. We think they could get in probably somewhere between 100 and 150 basis points in cuts.

* But not all at once because they want to be careful.

* Yeah, over time, starting in that second quarter. And so that could put downward pressure on the Loonie, potentially getting down to $0.71, $0.72.

* Yeah. I guess, too, at the same time, you're going to have the US, if they not follow. They manage their own, but cutting at the same time, you'll see some interesting things happening with the currencies then, too. But you still think the Loonie is going to depreciate?

* Yeah, I think there's a little bit of risk there. Now, one offset is that we'll have to see what oil does. Now, Canada doesn't trade on commodities like it used to, but it does put a floor under our dollar. And we are hearing a lot of rumblings. We've got OPEC quite unhappy with the level of oil prices, and so they've restrained production so much, in terms of shipments. Often supply is lagging. And so as the global economy gets into recovery stage, which we think will be in the second half of next year, we could end up with commodities, especially oil, in quite a bit of a deficit of supply. And that could at least put the floor under the Loonie, and then we'll see how the timing of the central banks work out.

* Also inflation. I'm just thinking that's there, too.

* Yeah, exactly. And then once the Federal Reserve is signaling cuts, the US dollar is going to come off well before then, and so you'll start to see it rebalance pretty quickly. But it might just be that knee-jerk reaction of Canada going first.

* Let me ask a really simple question to finish things off. I say in jest, what's going to happen with the world? But when you think about geopolitical instability-- Ukraine and Russia, Israel and Hamas, and the destabilization, I would say, of the Middle East area, upcoming elections in the States-- what are you watching, in terms of what's material for you?

* Oh, gosh.

* And not from all these things are material to everyone--

* Yeah.

* --but economically speaking.

* Yeah. I think such a complex question because everything, to that point, is material because everything is intersecting simultaneously. So an example is even with Israel and Hamas, if that war expands to include more pressures within the Middle East and bring in Iran, for example-- and if you had any disruption to the Strait of Hormuz, which ships out 20% of global demand for oil, whether it's refined or crude-- you would have oil prices easily $120, $130, $140, spiking up on that risk.

* So we're watching for escalation on that front. And you can imagine what that would do from the inflation perspective. It would be at least an extra percentage point on total inflation, in terms of its growth. So that's a risk.

* The elections. On the US side, again, typically you don't define those as risks, but they do inject uncertainty and volatility. We don't know yet who's going to be running in the presidential race for the Republicans, but if it's Trump, well, we do know that trade fragmentation is a central thesis of his policy. And Canada has been in the limelight with the US.

* In the wrong way.

* Yes. And so that injects a new level of uncertainty, at least on the Canadian side. So these risks continue to go on. Even the fact that there are now two wars underway, we still don't know how China and Taiwan will resolve. This puts pressure on domestic government budgets. So US and Canada and other countries are contributing to supporting their allies in these fights. But that means you're doing a tradeoff to your domestic budget and those priorities, and that could mean you have a higher risk premium on yields as a result of all this borrowing that's happening globally. So everything is under scope.

* Well, we'll have to have you back to talk about everything that's under scope, if you want to see what's landing. Beata, Thank you.

* My pleasure.

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