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The Soft Landing Challenge

April 29, 2022

Jimmy Jean
Vice-President, Chief Economist and Strategist

We got a bit of a surprise this week when we learned US GDP contracted by 1.4% in the first quarter. Thankfully, soaring imports were the cause, whereas domestic demand grew fairly robustly.

However, the big picture remains the same: economic growth will soften this year. In Canada, we expect the economy to cool significantly in the second half of the year. In part, this is because high prices have already started to bite. As we commented this week in our Spotlight on Housing, we expect home sales to keep weakening and there are signs that prices may have already peaked. This is especially the case in small metropolitan areas that have experienced outsized price increases since the beginning of the pandemic.

We’re also seeing inflation biting into household purchasing power. Some of the dynamics we marvelled at during the pandemic are shifting. Take disposable income, for instance. The big story in 2020 was how disposable income managed to increase despite a contracting economy. Fast-forward to today, and inflation-adjusted disposable income has dipped below its pre-pandemic trend.

A similar pattern can be seen in inflation-adjusted cash deposits. These are still slightly above their pre-pandemic trend, but they’re quickly converging to it. Higher mortgage rates are eating up more of the income available for discretionary spending, particularly for those with variable rate mortgages or fixed mortgages up for renewal soon. And the wealth effect is not supportive, as we expect a number of equity markets to deliver negative returns this year. All these factors are prompting governments to try to soften the blow. As we observed in our Budget Analysis this week, Ontario was the latest to roll out fiscal relief measures.

Whether these developments constitute fodder for a recession is a growing debate. There’s no law of nature stating that a combination of low unemployment, high inflation and the start of a hiking cycle means a recession must be imminent. In this cycle, a lot will depend on how inflation is tamed. If it requires interest rates going well above neutral, then yes, the risk of short-circuiting the expansion will increase substantially.

But this isn’t our baseline scenario at the moment. Given the forces already acting to rein in consumer spending—which is one of the first steps towards getting a handle on inflation—it still doesn’t look like central bankers will need to push interest rates very far above neutral. In Canada, we believe high sensitivity to interest rates will in fact prevent the Bank of Canada (BoC) from going above its stated neutral range. If so, excess demand for workers could start to ease and consumer spending and housing activity cool, but without the mass layoffs we’ve seen at the beginning of previous recessions.

We saw this dynamic play out in 2019. The Canadian economy grew at a sub-2% pace, rates were kept unchanged after the 2017–2018 rate hike cycle, and the unemployment rate was fairly stable during the year. Importantly, the BoC hadn’t brought rates above neutral because inflation was under control. We may see a similar outcome this time around, but that will be contingent on supply shocks finally abating. That’s not what we’ve seen so far this year. Achieving a soft landing is a difficult, but not insurmountable, challenge.

Read the full commentary: The Soft Landing Challenge