The Stakes are High for Monetary Policy

By Pedro Antunes

Central bankers in Canada, the United States and many other developed economies are nervous, anxious to see if the rapid increase in interest rates over the past year will have the intended outcome—slow economic activity and douse inflation.

The U.S. Federal Reserve and the Bank of Canada have increased their key lending rate by over 4 percentage points in record time over the past year. This has resulted in a similar rise in lending rates for households and businesses. The intent is to encourage households to spend less, lower economic activity and take further pressure off prices. Thus far, the policy is working in Canada. The volume of retail sales flattened over the last few months of 2022 and home sales and existing home prices have dropped sharply from the frothy activity we were seeing about this time last year.

More recently though, the rapid rise in interest rates has added another layer to market jitters. While all eyes were on the still-resilient consumer sector, the financial system came under strain as a few banks in the United States and Europe failed. Evidence suggests that these banks were mismanaged, such that the pressure of higher interest rates simply exposed existing problems, but the situation has nonetheless shaken confidence in the global banking system.

Fearing a much wider spread of financial panic, U.S. and European authorities have stepped in quickly to guarantee deposits and ensure liquidity to other banks to prevent the crisis from widening. One bank’s failure can lead to knock on effects at other banks as finances are interrelated. The immediate concern is that there will be more public (and social media) driven scrutiny of other banks. And no bank has enough liquidity to survive a bank run if concerns surface and depositors start withdrawing.

The turmoil had temporarily sent market interest rates plunging, even after a hawkish Fed chair Jerome Powell had signalled that benchmark rates would continue rising in a speech only a few days earlier. We believe Fed rate increases will resume, but that the peak is nearly here. The banking mini crisis has raised recession odds and probably ended up aiding central banks efforts to bring inflation rates down, but more progress needs to be made on that front before rates can be brough back down to neutral territory.

The inflation story is still with us, but progress is apparent. The price shocks brought on by the war in Ukraine started to subside in late spring 2022, helping inflation rates in the United States and Canada ease to below 6 per cent in the first months of 2023. Even Europe, where war impacts are highest, has seen recent progress on taming price growth. The Bank of Canada can afford to pause interest rate increases while it checks to ensure price pressures don’t reignite.  We see consumer prices growing within the Bank of Canada’s targeted 1-3 per cent band by early next year, which will allow for neutral or at least positive real wage growth going forward.

The labour market made an impressive start to 2023, marked by a rise in labour force participation and significant employment gains. Large employment gains are being fuelled by an uptick in population growth. International migration to Canada has risen sharply over recent quarters driven by record immigration targets and increased admissions of non-permanent residents, including temporary foreign workers. The rise in migration will contribute to employment and population growth in excess of 2 per cent in 2023.

Expanding labour supply is helping to soak up unmet labour demand in the Canadian economy, which surged in 2022 as pandemic restrictions fell away. Today, downward trending job postings and job vacancy data indicate that labour demand in the economy is moderating. As labour demand falls further over 2023, employment gains are forecast to soften, resulting in a modest rise in the unemployment rate.

We anticipate that oil prices will continue to soften throughout this year due to the ongoing global economic slowdown. With many developed economies facing high inflation and rising interest rates, we expect the demand growth for crude oil to remain sluggish, while output and inventories increase at a faster pace. As a result, we predict that the WTI price per barrel will average US$78.80 this year. Looking further ahead, we anticipate that inventories will continue to rise, leading to a further decrease in oil prices. Specifically, we project that the WTI price will average US$76.2 in 2024.

Through all this, our forecast for real GDP is keeping to the pattern of growth slowing through 2023 to a virtual standstill, with an eventual recovery beginning in early 2024. For the year, real GDP will expand by 0.9 per cent in 2023, followed by 1.4 per cent growth in 2024. A stronger 2.5 per cent rebound is expected in 2025 once the effect of rates falling back to neutral levels takes effect.

Pedro Antunes,           

Chief Economist, The Conference Board of Canada

Pedro Antunes is the thought leader and spokesperson for the Conference Board’s suite of economic forecast products, as well as other reports and economic indicators that relate to Canada and its regions. Mr. Antunes has provided expert testimony before parliamentary committees. He makes numerous presentations on economic topics and dialogues with Canadian leaders, the public and media about issues important to Canada.

Mr. Antunes joined the Conference Board in 1991 after working with the Canadian Forecasting Group at the Bank of Canada. In addition to his contribution to regular forecast products, Mr. Antunes led research on the impact of demographic change on the financial sustainability of public health care, productivity and other issues affecting the long-term economic growth for Canada and its provinces. He also worked on several international projects, helping decision-makers in Tunisia, Morocco, Jordan and Ukraine develop appropriate forecasting and policy analysis tools.

Pedro is fluent in both official languages. He is married with one son and enjoys hikes with his dog and playing soccer.

Mr. Antunes holds an M.A. (Economics) from Queen’s University and a B.A. (Honours Economics) from Bishop’s University.