HIGHLIGHTS OF THE WEEK
United States
- The U.S. job machine slowed in May (+138k jobs) as the unemployment fell to a sixteen year low of 4.3%. A pullback in the participation rate contributed to the fall in the unemployment rate.
- The Federal Reserve’s preferred measure of price growth slowed in April to 1.7% (from 1.9%), while the core measure fell to 1.5% (from 1.6%).
- Weak inflation will probably not forestall a rate hike in June, but continued weakness could be enough to delay further rate hikes. Just as much as job growth, this is an important metric to watch for guidance on future Fed action.
Canada
- Canadian real GDP rose 3.7% annualized in Q1, while nominal GDP rose 8.3%, marking the best threequarter streak in almost seven years.
- The household sector has contributed most to growth, due in large part to a hot housing market. Still, exports appear to be gaining momentum heading into the second quarter of the year.
- Preliminary data showed policy-induced soft market conditions in the GTA and GVA extended into May, bringing the durability of Canada’s growth prospects into question.
- Low interest rates will likely continue to support consumption amid a cool down in activity in Canada’s largest housing markets, providing upside potential to our 2017 growth forecast. Higher interest rates in 2018 should bring about a cooling in consumption and real estate.
UNITED STATES – THE FED’S CONUNDRUM: LOW UNEMPLOYMENT, SLOW INFLATION
The Federal Reserve has a conundrum. Its dual mandate is for maximum employment and price stability. On the latter, inflation has remained stubbornly below its 2% target. In April, the Fed’s preferred core inflation measure slowed to 1.5% from a recent peak of 1.8% in February.
On the former however, it’s becoming harder and harder to argue that the American economy is not nearing full employment. In May, the unemployment rate ticked down to 4.3% – its lowest level in sixteen years. Broader measures of unemployment, such as the U6 (which adds marginally attached workers and involuntary part-timers to the tally) also fell to 8.4% – its lowest level in nearly a decade.
In theory, a tightening labor market should be putting upward pressure on inflation. But, as noted by Federal Reserve Governor Brainard in a speech this week, even while the unemployment rate has fallen over five percentage points since the end of the recession, inflation has moved little. Headline consumer price growth has ebbed and flowed with energy prices, but core price measures have maintained a modest rate of change, notably under 2%.
There are a few ways to square this circle. The first, as referenced by Brainard, is that well-anchored inflation expectations have reduced the impact of economic slack on inflation. In economics jargon, the slope of the Phillips curve, may still be negative (inflation rises as unemployment falls), but it has flattened.
A second explanation is that even as unemployment has fallen, so has the theoretical unemployment rate associated with full employment. On this front, the median projection for the long-term unemployment rate among FOMC members has moved consistently downward. Given the recent moves in unemployment and inflation, there is a good chance that it will do so again in June. There is a good argument that an aging population puts downward pressure on the natural rate of unemployment. One can see this dynamic in Japan where the measured unemployment rate is at an all-time low, yet the economy continues to be plagued by deflation.
A third explanation is that the unemployment rate is no longer an accurate measure of labor market slack. While the more inclusive measures have also been falling, the still-limited rebound in core-age participation rates suggests more slack may exist. Alongside a potentially lower natural unemployment rate, this larger "shadow" gap could be diluting the inflationary impact of the tightening labor market.
A fourth explanation is that even while the U.S. labor market is tightening, a consistent and possibly expanding level of global economic slack is keeping downward pressure on inflation. With the Federal Reserve more responsive to domestic than global conditions, rate hikes to-date have put upward pressure on the dollar and helped to import global disinflation into America.
Putting it all together, the improvement in the labor market may provide the impetus for the Federal Reserve to continue to raise interest rates, especially if productivity remains weak and it is satisfied that wage growth is moving higher. Still, it cannot ignore the inflation side of its mandate. Continued underperformance on the inflation front will strengthen the case for patience and likely lead the Federal Reserve to slow the pace of rate hikes.
CANADA – ALL ABOUT THE HOME PRICE
Low oil prices have led to a softening in Canadian economic growth, but they didn’t hold it down. National accounts data for the first quarter was released this week, and what a quarter is was. Real GDP grew by 3.7% q/q annualized with the economy now on the best three-quarter growth streak since 2010. Canadian nominal GDP surged 8.3%, building off the strength in real activity and a 14% rise in oil prices, for its best quarterly performance since 2010.
Despite exports still struggling to gain momentum, the economy has benefitted from strength in the household sector, particularly real estate, to drive growth. The combination of real residential investment and spending on housing related items (utilities, furnishing and equipment) rose by almost 11% in the first quarter contributing to about threequarters of economic growth. Consumers have also been spending on just about everything at a healthy rate, supported by a positive wealth impact stemming from a $21,000 appreciation in average home prices over the quarter.
The strong dependence on the household sector throws into question the durability of Canada’s economic performance, particularly in light of an ongoing policy-induced adjustment in housing activity in both BC and Ontario. Indeed, the pace of spending is likely to moderate going forward, but the consumer is expected to continue to carry the economy for just a little longer. For one, while the BC housing market adjusted during much of last year, provincial growth still notched up very strong growth of 3.7% last year. This offers some consolation that a cool down in housing won’t derail Canada’s economic prospects. Even as existing home sales adjust to more normal levels, housing starts are still elevated due to the lagged impact of double-digit home price growth, which is expected to continue to prop construction activity through the remainder of the year.
Meanwhile, low interest rates should continue to help support the consumer. While household debt (5.2% y/y in Q1) continues outpace personal income (+4.1% y/y in Q1) and households are arguably carrying too much debt, the cost of borrowing is still low. Households are paying down their principal at a faster rate than has historically been the case and the interest portion of monthly debt payments hit a new record low in the first quarter of the year, both in absolute terms and as a share of income.
There is some hope on the export front too. This week’s export data indicated that real exports rose 0.8% in April atop an already strong 1.3% gain in March, telegraphing a strong start to second quarter net-trade. However, the momentum in exports over the last two months has mainly been an energy story, with more than two-thirds of the yearly Canadian export growth stemming from energy products.
Overall, even as Canada’s largest housing markets come back to earth, the consumer will likely keep on chugging along, suggesting some upside to our economic forecast for this year. But, with the economy on a stronger footing, the Bank of Canada is expected to start raising rates as early as spring 2018, putting downward pressure on consumer spending and residential investment. The plan is that, by then, exports and business investment will have started to pick up.
