September 28, 2022
  • September 28, 2022

The Weekly Bottom Line: How fast to raise rates? That is the question

By on August 20, 2022 0

United States Highlights

  • Total retail sales remained flat in July, marking a deceleration from the June pace. However, control group sales, which exclude several volatile categories and are used in the calculation of GDP, rose a solid 0.8% m/m.
  • Housing continued to cool in July. Sales of existing homes fell 5.9% and the seasonally adjusted median home price fell for the second consecutive month. Homebuilders also continued to slow the accelerator, with housing starts down 9.6% in July.
  • Minutes from last month’s FOMC meeting revealed that many participants acknowledged the risks that the Committee could tighten policy stance “more than necessary.”

Canadian Highlights

  • Headline inflation cooled somewhat to 7.6% yoy in July due to lower fuel prices. However, inflation remains uncomfortably high and does not hit all households equally.
  • Core inflation measures rose last month, supporting the case for an aggressive BoC hike in September.
  • Growth indicators released this week generally confirmed slowing economic growth. The BoC faces an increasingly difficult task of staging a soft landing.

United States – How fast to increase tariffs? That is the question

The third week of August was a busy data week for the United States, with housing and consumption updates for July. The consumer spent slightly more than expected at retailers (omitting car dealerships and gas stations), thanks to a successful Amazon Prime Day event, but housing continues to recalibrate in a higher rate environment.

Overall retail sales were flat in July, marking a deceleration from June’s 0.8% month-over-month (m/m) gain. However, the main measure was dragged down by sales at auto and parts dealers (-1.6%) and gas stations (-1.8%), the latter reflecting lower prices at the pump. Retail sales of all other categories grew solidly by 0.7% m/m. Similarly, sales of the control group, which removes a few additional categories from the total and is used in the calculation of personal consumption expenditure and GDP, increased by 0.8% m/m thanks to an increase in retailer sales. non-store (Chart 1 ). Headline CPI inflation was stable in July, so by these measures, consumer spending on real goods appears to have gotten off to a decent start in the third quarter.

Consumers also spent generously at building materials and supplies dealers last month (+1.5% m/m), a move that bucks the ongoing weakening in housing. Existing home sales fell nearly 6% in July, extending their early year plunge to a staggering 26%. Home prices have also felt the impact of higher rates, with the seasonally adjusted median home price falling in each of the past two months (Chart 2). The fact that mortgage rates have eased a little in recent weeks could give the real estate rout an opportunity to breathe a little. However, the Fed is not done raising rates, so affordability will likely remain a major constraint for the foreseeable future. As a result, we expect home sales to continue to decline moderately in the first half of next year.

Homebuilders continued to slow the throttle in this tough market environment, with housing starts down 9.6% in July. The weakness in residential construction in recent months has been concentrated in the single-family home market. A recent sharp drop in homebuilder confidence in this sector suggests the trend is set to continue.

The fallout from the slowing housing market is just one factor the Fed needs to consider as it prepares to raise rates again next month. Minutes from last month’s FOMC meeting revealed that many members recognized the risks that the Committee could tighten policy stance “more than necessary.” Furthermore, participants felt that as the policy rate tightens further “it would become appropriate, at some point, to slow the pace of policy rate increases” to assess the impacts. Markets interpreted this as a signal that the pace of rate hikes would slow soon, but a few Fed officials (e.g. voting member Bullard backs an upcoming 75 basis point (bp) hike) seemed reject this idea. For now, the markets are anticipating a 50 basis point hike at the next meeting. President Powell’s speech in Jackson Hole next Friday will be closely watched to gauge the Fed’s latest thoughts on the direction of the rate hikes.

Canada – Warm to the Core

Canadian financial markets had their eyes glued to this week’s inflation report – the last before the Bank of Canada‘s rate decision on Sept. 7. Bond markets reacted by pushing short-term yields a little higher for the week, as underlying inflationary pressures intensified in July. We expect the Bank of Canada to raise its key rate by 50 basis points (bps) at its September meeting, but the inflation data puts the risk at 75 bps.

Whether it’s 50 or 75 basis points, the move is unlikely to cause the same sticky shock as their surprise 100 basis point rise in July. However, this would still represent an aggressive increase and would be consistent with Governor Macklem’s message that it is better to anticipate the tightening now, rather than having to be more aggressive later. It probably won’t be their last hike either. As detailed in our last quarterly outlook article, they communicated the need to move rates above their neutral range estimate (i.e. above 3%) to maintain credibility.

Looking at the details of the July CPI data, headline inflation cooled somewhat to 7.6% y/y on the back of a sharp drop in fuel prices. However, the measure that policymakers tend to place more weight on is core inflation. Almost all core inflation measures picked up in July (Chart 1). Even metrics that didn’t rise, like CPI-trim, remained uncomfortably high, pointing to an aggressive salvo in September.

An inflation rate of 7.6% is still far too high and high inflation affects everyone, but not to the same degree. Our research published this week indicates that middle-income households have probably been hardest hit by inflation, given their relatively high share of spending on food and transportation.

Ultimately, inflation saps purchasing power and weighs on growth in real terms, and this week featured a series of releases offering insights into where growth is headed. The main message from almost all of these indicators is that growth is slowing (chart 2), in line with the soft flash estimate of monthly GDP growth in June. Additionally, TD’s internal high-frequency credit and debit card spending data shows signs of slowing as the summer progresses.

The Bank of Canada forecast slower growth in the third quarter in its July MPR, and some easing in economic activity is needed to bring inflation down. Like the Fed, the BoC is trying to engineer a “soft landing” scenario, in which economic growth is below trend for a while, but still positive, and inflation cools. This is an incredibly difficult balance to strike, and with the continued warmth of underlying inflation, the odds of this outcome likely diminishing.