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While markets brace for a possible U.S. recession, there are signs of optimism. Thomas Feltmate, Senior Economist at TD, tells Greg Bonnell that resilience in both employment and consumer spending may be indication of a less gloomy outlook than previously expected.
Transcript
Greg Bonnell: With slowing growth on the minds of many investors, what are the chances of the world’s largest economy tipping into a recession this year? Joining us now to discuss, Thomas Feltmate, senior economist with TD. Thomas, great to have you here. And this is the big question, right? After a year of aggressive rate hikes, what does it do to the economy? What does it do to the US economy?
Thomas Feltmate: Yeah, that’s the million-dollar question right now of whether or not the US economy is going to tip into a recession. I think, if we just kind of take a step back and we look into 2022, Q3 growth was relatively strong, coming in over 3% on a quarter-over-quarter annualized basis. We still don’t have that Q4 data print yet, but by all intents and purposes, things are tracking somewhere close to 2.5%. And embedded in that is a tracking on consumer spending that’s looking to be about 3% on a quarter-over-quarter annualized basis. So, to give some context here, that’s going to be the healthiest pace of consumer spending that we would have seen in 2022. And to your point, it’s kind of coming at the end of the year, after that cumulative 425 basis points of tightening from the Fed.
So we’re definitely seeing some degree of resilience on the consumer side of things. So this isn’t necessarily indicative of what we would think of an economy that would be on the cusp of a recession.
We also kind of look to the labor market. We just got employment data a few weeks ago for December. The US economy added 223,000 jobs, still a pretty healthy level of employment gains on a monthly basis. The unemployment rate fell to 3.5%. Again, this is the lowest level that we’ve seen in nearly 50 years. So again, not necessarily indicative of a recession over the next three to six months, not just yet at least.
Greg Bonnell: It’s been a very strange couple of years, probably the understatement of the show. [LAUGHS] I’ll take the understatement of the show. Are things not adding up, though? Because we talked about the aggressive rate hiking cycle. The consumer is resilient. The labor market is resilient. Looking at some other data points, the New York State manufacturing number came out this morning. And there seems to be some weakness in that part of the economy. Are things sort of uneven at the moment?
Thomas Feltmate: I think that’s probably fair to say. I mean, when we look across the suite of different manufacturer or service sector indicators for December, we’ve definitely seen some softness coming through across all readings. So I think it could be indicative of the rapid pace of adjustments finally playing some degree of catch up on the economy.
Economists have been beating on this drum for the past year, that the rate hikes– there is some time for those to kind of play into the economy. And that can take anywhere from 12 to 18 months. We know monetary policy acts with a lag. And to some degree, we are starting to see this now playing out. But I think there is probably some degree of resilience still in the economy today, particularly on the consumer side of things, which could perhaps help it stave off a recession.
Greg Bonnell: Now, that would be the fine balancing act, where the Fed– the whole reason in our central bank here and other central banks, to raise rates so aggressively– is trying to put the brakes on things. Bring inflation down. They’ve warned us that’s going to mean a little bit of pain and perhaps an economic slowdown. But if we’re not going to get the slowdown, what do the central banks have to do? Where is the happy spot for them right now, to try to figure all this out?
Thomas Feltmate: Right. So I think we are definitely going to get the slowdown. I mean, if we look at what our expectations are for growth, for both this year and next year, we’re expecting kind of a sub-1% pace of growth, which we compare that to where we were and how 2022 is shaping up, that’s going to be about half the pace of growth that we saw last year. So definitely some deceleration in underlying activity there.
I think where the Fed is nearing now is a point where they’re likely going to reach a point over the next couple of months where they’re going to pause on rate hikes. So our expectations are and when they meet in February, likely further dialing back on the pace of rate hikes, going to something more normal of a 25 basis point move, and then probably something similar again in March, where we see another 25 basis point hike. This will get the terminal rate up to about 5%.
And we’ve kind of seen some expectations coming in from markets where they’re almost cheering this, that the end of the tightening cycle is near. But I think the one thing that might be getting lost in all of this is that, while the terminal rate might be reached over the next couple of months, the real effective policy rate is going to continue to increase as nominal rates stay elevated, but then inflation is going to be falling.
So to give some context, we have about 50 basis points of tightening over the next couple of months from the Fed. But from an inflation-adjusted perspective on that real rate, we’re going to see an increase on the policy rate of about another 200 basis points through this year.
Greg Bonnell: That’s pretty important to think about in terms of the long-term trajectory of what the central banks are up to, what it could mean for the economy. There seems to be a bit of a disagreement, too, if you look to the bond market and what they think the US Federal Reserve or other central banks are going to do later this year and what the central banks tell us they’re going to do.
The central bank’s basically saying, we’re going to get to a certain point then we’re going to stay there because we don’t want to make the mistake, which has been made in the past, of then reversing too quickly. And the bond market’s like, nah, we don’t really believe you all that much. Is this sort of a battleground this year to see who’s right?
Thomas Feltmate: Yeah, I think that’s probably a fair assessment. I think what we’re seeing right now in the bond market is they’re definitely acknowledging some of the softer reading in particular that we saw in the employment report from the wage side of things. So we saw revisions to the prior months show that wage growth was a bit weaker. And then certainly we saw a deceleration at just 0.3 month-over-month growth in December, which came in below market expectations. So that was certainly one reading to suggest that maybe things are a bit softer than previously expected.
And then, in the December inflation report, as well, we are getting more convincing evidence that inflation is indeed starting to roll over. And I think that’s giving market hope, some optimism that things could turn a bit quicker than the Fed is currently anticipating.
Greg Bonnell: How is that path looking? Because underpinning all of this, of course, is inflation and trying to bring it back down to a target range. We’ve got the latest Canadian print, which shows easing on the headline. The last US print shows easing on the headline. So things are moving in the right direction but, at the same time, still far above the target range. What kind of glide path are we on to sort of get back to a normal inflation print?
Thomas Feltmate: Yeah, so I think through the latter half of last year, we definitely saw inflation kind of peak in June and then start to turn lower in the second half. So the headline measure came down by about 2.5 percentage points. We saw core CPI fall by about a percentage point from its peak. And really and truly, what was really driving the downward pressure on prices were falling energy prices, which fell by about 15% in the second half of the year. And then we did see, in more recent months, core goods prices roll over. Now, this is kind of a byproduct of a few things. We’re seeing some normalization in supply chain issues, which definitely put a lot of upward pressure on prices earlier in the pandemic. And then we’re also seeing consumer demand pivot away from more goods-oriented consumption towards more service-based consumption. So that’s allowed goods prices to really start to kind of roll over.
Now, the interesting thing here is goods only account for about 25% of that core CPI basket. So there’s only so much disinflationary pressure that can come from that part of CPI. The rest, and the majority of the heavy lifting, has to come from the service side of things. And I think here’s where we’re seeing a lot more stickiness.
So when we’re thinking about service inflation, really, we can kind of bucket it into two categories. We have the shelter component and then that ex shelter component. And through the latter half of last year, we saw a continued acceleration in that shelter part of CPI.
And this is kind of at odds with what we’re seeing from market-based measures of rent, which are showing that things have kind of peaked and have started to roll over. But it takes considerable time for that to really roll over into the stock of outstanding leases, which ultimately is what’s feeding into CPI and is going to generate that downward pressure on inflation from the shelter side of things.
If we strip that out, and we’re looking at just the other core services of ex shelter, these are kind of the more labor-intensive service categories. And here, we can think of things like airfares, haircuts, cleaning services, et cetera, so definitely more labor-intensive. And in these industries, we’re still seeing job opening rates at historically elevated levels. And that’s leading to a lot of wage pressures. And those are ultimately being passed on to the consumer.
So really, the linchpin on inflation of getting that second leg lower is going to be cooling the labor market such that we see wage pressures ease. And then those lower labor costs are ultimately what’s going to be passed on to the consumer, which will create some disinflationary pressure from the inflation side of things.
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