Concerns about inflation are overblown, according to economists at the big Canadian banks.
Granted, inflation has been edging upward, but a slowing U.S. economy will probably moderate its impact. Nor do financial markets seem very concerned, says Doug Porter, deputy chief economist at BMO Capital Markets in Toronto. Ten-year Government of Canada bonds have added just 30 basis points from the year’s starting point of 4%, and 10-year U.S. Treasuries are up just 10 bps, he notes.
Nevertheless, there is enough inflation risk — combined with tight labour markets and strong U.S. consumer demand — to keep the U.S. Federal Reserve Board and the Bank of Canada on the alert. If inflation continues to rise, the central banks are ready to raise interest rates; if inflation moderates and the U.S. economy slows significantly, they will cut rates.
Accordingly, the consensus among economists in the financial services industry is for steady but slower growth. U.S. real gross domestic product will grow by only 2% or so this year, then rebound to almost 3% in 2008. Canada will do marginally better than the U.S. this year, but grow by a touch less in 2008.
Inflation is likely to remain at more than 2% but less than 2.5% in both countries. And most economists expect U.S. interest rates to come down slightly this year, then hold steady or move up slightly in 2008. In Canada, little change is expected to rates this year, while a small increase is likely in 2008.
There are, however, exceptions. Craig Wright, chief economist at Royal Bank of Canada in Toronto, is the most optimistic of the economists surveyed when it comes to U.S. growth, pegging it at 2.4% this year and 2.9% in 2008. He’s less impressed than other economists with the argument that U.S. consumers are so indebted that they need to increase savings to get their financial houses in order. He believes in comparing debt to assets and assessing the cost of servicing debt rather than taking debt as a percentage of personal disposable income. He notes that assets have risen with the housing boom, while debt servicing is affordable because of low interest rates.
Once it’s clear economic growth will resume at a healthy pace, Wright thinks interest rates will rise. He sees the Fed discount rate ending 2008 at 5.75%, vs the recent 5.25%, and the Bank of Canada rate at 5.25%, up from 4.25%.
Clement Gignac, chief economist and strategist at National Bank Financial Ltd. in Montreal, is the pessimist of the group. He expects the slowdown to persist throughout next year, with U.S. growth at 2% this year and 1.9% in 2008; Canada will come in a touch higher.
As a result, Gignac is forecasting cuts of 75 bps in U.S. short-term interest rates by the end of this year, to 4.25% for the Fed discount rate from the recent 5.25%. Then rates will drop by another 100 bps in 2008.
It’s Gignac’s view that the rate reduction will be less in Canada because our economy is in better shape. In addition to Western Canada’s strong economy, the housing market across this country is not as weak as it is in the U.S. Gignac expects average national house prices in the U.S. to drop by 12%-15%, and notes that continued high oil prices will eat into consumers’ purchasing power.
(Most other economists think housing prices will stay around current levels. Bank of Nova Scotia senior economist Adrienne Warren argues that both consumers and builders are reluctant to lower house prices.)
Another factor in Canada’s favour, Gignac says, is that there’s more fiscal stimulus in Canada. And interest rates are lower than those in the U.S. He sees the Bank of Canada rate falling to 3.75% this year and then to 3.25% in 2008, when it will be the same as in the U.S.
Gignac does not rule out a recession, putting the odds at 40%. That compares with the 25%-30% probability given by Porter and the 20%-25% by Warren. Both Wright and Don Drummond, chief economist at TD Bank Financial Group in Toronto, say the odds are small; Wright puts them at 10% — there’s always some risk, he points out.
All the economists have been surprised by the resilience of the U.S. consumer in the face of the deteriorating U.S. housing market, continued healthy economic growth outside of the U.S. and the strength of resources prices. Nevertheless, economists expect some slowing.
@page_break@Gignac has increased his forecast of average oil prices for 2007 to the consensus level of US$61 a barrel from the US$50 he had been expecting at the beginning of the year. The price is being supported, he says, by strong Asian demand and a higher risk premium because of concerns about supply disruption, given the low output from the Organization of Petroleum Exporting Countries and geopolitical tensions in the Middle East. But he remains skeptical about this price level being sustained over the medium term.
Again, others differ, believing that the strength of demand in Asia, the region’s continuing growth prospects and healthy growth in Europe suggest oil prices are unlikely to go below US$60 a barrel over the next few years. As Royal Bank’s Wright points out, much of the demand is coming from Asia, which is a less efficient user of energy and other commodities.
Metals prices have also remained buoyant, and economists expect this to continue, although — again — Gignac remains skeptical that the price strength will continue into the medium term. But strong oil and metals prices have raised expectations that the Canadian dollar will stay around US90¢, presenting further challenges to Canada’s manufacturing exporters.
Gignac has the most bullish forecast for the C$, expecting the loonie to average US95¢ in 2008 and US$1 in 2009. That’s based on Canadian and U.S. interest rates converging in the next 12 to 18 months — which most of the other economists don’t expect.
In addition, Gignac notes that Canada has the best public finances of the G-7 countries and Canadian resources assets remain attractive to foreigners, even with some decline in the oil price over the medium term.
Other economists expect the C$ to stay at US90¢ or slightly higher this year, and to still be in the high-US80¢ range in 2008.
Continued moderate inflation is key to these forecasts. Economists note that the biggest danger is upward price pressure feeding into wage demands. But that hasn’t happened yet.
There was an upward blip in U.S. wage gains last year, but forecasters expect demands will moderate with slower U.S. growth. Elsewhere, says TD’s Drummond, “Wages aren’t going anywhere.”
He argues that, in an age of globalization, the threat of companies moving production elsewhere ensures that wage demands remain moderate.
As a result, he says, “There hasn’t been a big correlation between resources prices and retail prices over the past few years.”
Among the economists, BMO’s Porter is the most concerned about inflation, noting that upward price pressure has broadened to the food sector. This is partly due to higher energy costs, which have pushed up corn prices because of demand for the alternative fuel, ethanol. This feeds through to higher prices for meat and dairy, as well as bread. He doesn’t, however, expect this to spill over into wages, given the slowing economic growth.
Porter is forecasting 3% inflation in the U.S. in 2008, up from 2.4% this year. But he doesn’t think the Fed will need to raise interest rates to quell the upward pressure. Indeed, he expects the Fed to cut rates by 50 bps this fall to provide stimulus to the U.S. economy.
But Porter does think the Bank of Canada will raise rates slightly in 2008, based on less downward pressure on inflation from out housing market. His forecast is for a Fed rate of 4.75% and a Bank of Canada rate of 4.5% at the end of 2008.
NBF’s assistant chief economist, Stephane Marion, shares some of Porter’s concerns. But Marion is more worried about Canada and the potential for upward pressure on wages in Western Canada. Given that he expects a severe and lengthy slowdown, he believes inflation will move downward, not upward. His forecast is for the U.S. consumer price index to rise only 1.8% in 2008, following a 2.8% increase this year, while Canadian inflation will fall to 1.4% from 2.5% in 2007.
Marion expects the drop in national house prices in the U.S. to moderate the rise in the U.S. CPI, noting that rents have a heavy weighting in the index.
There is already some moderation in the increases in the Canadian new-house price index, which he thinks will continue.
China remains a risk on the horizon. Attempts by Chinese authorities to slow their economy haven’t had any impact, and the economy continues to expand at a 10%-plus pace. The danger is that too much braking could be applied, particularly if it coincides with a severe slowdown in the U.S., such as NBF expects. Marion notes that the U.S. accounts for 75% of China’s trade surplus. IE
Inflation fears overblown
- By: Catherine Harris
- May 29, 2007 May 29, 2007
- 09:19