The Weekly Bottom Line: The Fed is setting the stage for rates to take off soon
United States Highlights
- The Fed left its key rate unchanged at this week’s FOMC meeting, but signaled that a rate hike was imminent in March. Uncertainty over the pace of increases after March remains elevated, contributing to equity market volatility this week.
- The U.S. economy grew 6.9% (annualized) in the last quarter of 2021 – a notable acceleration from the 2.3% pace of the previous quarter. The growth was fueled by an accumulation of inventories.
- Consumer spending ended the year on a soft note, with real spending down 1.0% (m/m) in December. Pending home sales also ended the year on a weak footing, falling 3.8% last month.
- The Bank of Canada kept its key rate stable this week, surprising the markets. Still, the overall message was hawkish, as was Governor Macklem’s press conference, dampening the market’s dovish reaction.
- The Bank of Canada pointed out that the economic slowdown has been absorbed, but almost launched a rate hike in early March. They will also initiate a roll-off of the balance sheet, but only after the key rate has started to rise.
- The outlook for interest rates is highly dependent on inflation. Should it prove more difficult to tame, the Bank could proceed with a more aggressive hike.
United States – The Fed is preparing the ground for rates to take off soon
The last week of January was packed with data reports, but the FOMC meeting absorbed much of the attention. As the Fed left its key rate unchanged, it issued its clearest warning yet of impending rate hikes. A March rate hike is now all but guaranteed, with market odds currently pegged at over 95%. This is probably only the beginning of what will certainly be a sequence of hikes. Concerns about future monetary tightening contributed to equity market volatility this week. Ultimately, the pace of rate hikes will depend on the pandemic, global supply chains and how aggregate demand responds to higher rates.
The economy ended last year on a strong note, with a 6.9% annualized jump in real GDP in the fourth quarter. The acceleration in growth was fueled by significant restocking. Inventories contributed 4.9 percentage points to the overall tally, accounting for more than 70% of growth in the quarter (Chart 1). Inventory accumulation was led by the retail and wholesale industries, with retail auto inventories leading the charge. Business investment (+2% yoy) and consumer spending (+3.3%) also contributed to growth, while a decline in government spending (-2.9%) detracted slightly to growth.
Last quarter’s strong performance largely reflects activity before the Omicron infection wave took hold. Other data this week also indicated a slowdown in economic momentum at the turn of the year. The December Personal Income and Expenditure Report showed that real spending fell 1.0% in the month, mainly due to a decline in spending on goods. Spending on services remained in positive territory, but spending on restaurants and bars declined, likely reflecting consumer caution amid rapidly rising COVID-19 infections. Convenience services are expected to experience further weakness in January as high-frequency indicators point to a slowdown in areas such as air travel.
Inflation adds to consumer woes. Echoing the acceleration in the consumer price index, inflation as measured by the personal consumption expenditure (PCE) price index reached 5.8% year-on-year (y/y) in December. Meanwhile, the core PCE – the Fed’s favorite inflation gauge – accelerated to 4.9% year-over-year, moving further away from the Fed’s target (chart 2).
Tier 2 data reports also point to slower near-term growth. Pending home sales fell 3.8% in December, marking the second consecutive monthly decline for the series. Pending sales are ahead of actual (closed) sales by 1-2 months, with recent weakness indicating a soft start to the new year. The housing shortage is a key driver of the year-end weaker trend. At the start of the year, rising mortgage rates and the unease of potential buyers during a spike in COVID-19 infections are also likely to weigh on activity.
The good news is that the Omicron wave is likely to pose a temporary impediment to economic activity. New infections in the United States appear to have peaked. As the economy clears this hurdle, growth is expected to rebound from a modest sub-2% pace this quarter to a much faster pace in the spring. Inflation, however, is expected to remain elevated through 2022, although it decelerates from current highs (see here).
Canada – Walk to Hike
To the surprise of many, the Bank of Canada chose to keep its key rate stable in Wednesday’s highly anticipated interest rate decision. In the accompanying press conference, Governor Macklem noted the current (but improving) situation with Omicron and the Bank’s preference to adequately prepare the public for higher interest rates as factors holding back the hand. form the bank. The desire to formally conclude the forward directions and the fact that the next meeting will only be held in five short weeks probably also helped.
That said, it was the definition of a warmongering hold. The Bank stressed in the statement and in the accompanying Monetary Policy Report (MPR) that the economic slowdown has now subsided and will begin to rise at its next meeting in early March. What’s more, the Bank has left the door open for a rapid transition to balance sheet roll-off (ie quantitative tightening). While that is unlikely to be in play for the March meeting, the governor noted that the central bank will “consider” this step once interest rates begin to rise.
Critics of the decision note that a rate hike would have been very much in line with the Bank’s forecast that it would not raise the overnight rate until the economic downturn subsided. However, the high degree of uncertainty around this estimate – the MPR has defined a range on its output gap measure of between -0.75% (positive margin) and +0.25% (negative margin) – argued for an advanced warning. Omicron appears to have added to the caution, as the restrictions saw Q1 growth expectations revised down to just 2%.
We know the Bank will be raising rates soon, but the speed and extent will depend on the outlook for inflation. It’s safe to say that with Omicron’s worsening supply disruptions, it will remain well above target for the foreseeable future, enough to warrant starting to reverse an inflation-adjusted policy rate. profoundly negative and urgent (Chart 1). We anticipate at least two moves over the next three meetings. If all goes well, a rate hike roughly every two meetings through 2023 will bring the overnight rate back to its pre-pandemic level (Chart 2).
A slower cadence is also possible. After an initial round of measurements, policymakers might very well choose to sit down for a few months and assess the balance between supply and demand. There is a precedent for this. In 2017, the Bank rose twice in the third quarter of the year and paused in the fourth before picking up again in early 2018.
However, should inflation prove more persistent, the Bank would likely take a more aggressive approach. We have become accustomed to policy rising in 25 basis point increments (the last time the Bank raised more than this in a single meeting was in May 2000), but this has been a relatively low price growth environment. weak and stable. At the same time, the Bank could simply raise interest rates for longer, ultimately pushing the overnight rate above its estimated “neutral” rate. With the highest inflation in thirty years, drastic times may call for drastic measures.