Bank of Canada will not be happy with this inflation report

Not only did the headline CPI inflation rate stall at 6.9% last month, but the core CPI numbers remain stubbornly high. Food inflation–a highly visible component–edged down slightly. Still, prices for food purchased from stores (+11.0%) continued to increase faster year over year than the all-items CPI for the eleventh consecutive month. Bonds fell on the news, with Canada’s two-year yield rising to 3.877% at 8:43 a.m. Ottawa time, about 3.5 basis points (bps) higher than its level before the data release. The yield on 5-year Government of Canada bonds spiked temporarily on the release of these disappointing inflation data. This was in direct contrast to the US, which posted a better-than-expected inflation reading for October last week.

Less than two weeks after a stronger-than-expected jobs report, the inflation numbers continue to show the economy in overheated territory. Bank of Canada Governor Tiff Macklem has said that rates will need to continue to rise further while acknowledging the end of this tightening cycle is near.

Traders are pricing at least a 25 basis-point increase at the next policy decision on Dec. 7, with a 50-50 chance of a half percentage point hike. The central bank has increased borrowing costs by 3.5 percentage points since March, bringing the benchmark overnight lending rate to 3.75%.

A significant factor in the Bank’s decision process is the continued rise in wage inflation to a 5.6% annual pace in October. If inflation expectations remain robust, wage-price spiralling becomes a real threat.

Bottom Line

Price pressures might have peaked, but today’s data release will not be welcome news for the Bank of Canada. There is no evidence that core inflation is moderating despite the housing and consumer spending slowdown. The average of the Bank’s favourite measure of core inflation remains stuck at 5.3%. The central bank slowed reduced its rate hike at the October 26th meeting to 50 bps, and while some traders are betting the hike in December will be 25 bps, there is at least an even chance that the Governing Council will opt for an overnight policy target of 4.25%.

Inflation is still way above the Bank’s 2%-target level. Ultimately, it will take a higher peak interest rate to break the back of inflation. I expect the policy target to peak at about 4.5% in early 2023 and to remain at that level for an extended period despite triggering a mild recession in early 2023.

Very strong employment report for October 

Today’s Labour Force Survey for October was surprisingly strong, boosting wage inflation to an eye-popping 5.6% year-over-year pace. While good news for the economy, this is terrible news for the inflation fight–just when the Bank of Canada eased its foot on the brakes. The two-year and five-year Government of Canada bond yields spiked on the news, calling into question the Bank of Canada’s decision last week to trim the rate hike to 50 bps rather than the 75 bps that was expected. While one month’s data is not enough to draw too fine a point, this does call into question the assumption that fourth-quarter growth will be substantially less than 1%.

Following four months of declines or little change, employment rose by 108,000 (+0.6%) in October. This increase—widespread across industries, including manufacturing, construction, and accommodation and food services—brought employment back to a level on par with the most recent peak observed in May 2022. All of the gain in October was in full-time work, another indicator of economic strength. This was the first gain among private sector employees since March when the Bank of Canada began hiking interest rates.

After declining in September, the unemployment rate remained at 5.2% in October, 0.3 percentage points above the record low of 4.9% observed in June and July. The adjusted unemployment rate—which includes people who wanted a job but did not look for one—was virtually unchanged in October at 7.1%.

In October, the labour force—or the total number of people who are either employed or unemployed—was 110,000 (+0.5%) more significant than in September. The labour force participation rate rose 0.2 percentage points to 64.9% in October but fell 0.5 percentage points short of the recent high of 65.4% in February and March 2022.

Employment rebounded in construction and manufacturing. The number of people working in construction rose by 25,000 (+1.6%) in October, with increases in five provinces, including Quebec (+17,000; +5.9%) and British Columbia (+6,000; +2.5%). Despite this increase, employment in construction was virtually unchanged in October compared with March 2022, consistent with the latest data on gross domestic product showing slowing economic activity in the industry over a similar period.

Employment rose by 24,000 (+1.4%) in manufacturing, mainly offsetting the decrease of 28,000 (-1.6%) recorded in September. Most of the increase was attributable to British Columbia (+12,000; +6.9%) and Nova Scotia (+3,700; +11.6%). On a year-over-year basis, employment in manufacturing was little changed.

The number of people working in accommodation and food services increased by 18,000 (+1.7%) in October, the first increase in the industry since May. According to the latest data from the Job Vacancy and Wage Survey, the industry had a higher job vacancy rate than all other industries in August.

Employment in professional, scientific and technical services rose by 18,000 in October (+1.0%), the third increase in six months. The number of people working in the industry has followed a long-term upward trend since June 2020, and in October was 297,000 (+19.3%) above its pre-pandemic level.

In October, the number of people working in wholesale and retail trade declined by 20,000 (-0.7%). Employment in the industry last increased in May and was little changed on a year-over-year basis in October. According to the latest data on retail trade, while retail sales increased 0.7% to $61.8 billion in August, advance estimates suggest that sales decreased 0.5% in September.

Of paramount importance to the Bank of Canada’s endeavours to wrestle inflation to a 2% pace, average hourly wages last month were 5.6% higher than one year earlier, accelerating from a rate of 5.2% in September. Despite average wages growing by more than 5% on a year-over-year basis in each of the past five months, they have not kept pace with inflation, which was 6.9% in September, contributing to concerns about affordability and the cost of living for many Canadians.

In separate news, the US employment data for October were also released today, showing stronger-than-expected hiring and wage gains, while the jobless rate ticked up a bit more than expected.

Bottom Line

Today’s labour force data in Canada throws into question the widespread assumption that the Bank of Canada can ease off the brakes very soon. I believe Governor Tiff Macklem will hike rates by another 50 bps in December and continue with 25 bp increases early next year. Today’s employment report raised the odds of the peak in the policy target of 4.5%.

The following article was posted by one of my lenders, First National, and has insights into current housing trends.  Enjoy!

Residential Mortgage Commentary – Misleading averages

Since interest rates started climbing back in March there has been a lot said about declining home prices in Canada.  Broadly speaking, market watchers have been forecasting a 20% to 25% drop – from the February peak – in the average price by the end of this year.

Those are dramatic numbers, but they are deceiving.  When it comes to housing, simple averaging is good for making broad comparisons over an extended period of time.  But simply dividing the total value of home sales by the number of homes sold lacks the nuance needed properly measure the state of the market.

The average price is influenced by the number of sales, but also by the composition of those sales.  That is: the type, location and price of the homes sold.

In a recent note, CMHC Deputy Chief Economist, Patrick Perrier, points out that the seasonally adjusted average MLS price for the entire country fell by 15.6% between February and August of this year.  He also points out that lower-priced properties made up a growing proportion of total sales during that period.

At the height of the pandemic detached, single family homes were a leading driver of sales.  But, since interest rates started to climb, lower-priced condominiums have become more popular.  Perrier says, that change in the composition of the market could account for more than half of the 15.6% price drop mentioned above.  That would mean that the real weakening of prices is actually closer to 7%.

The MLS Home Price Index, used by the Canadian Real Estate Association, accounts for market composition.  It put the price decline at 7.4%.  The Teranet House Price Index also tracks market composition.  It showed a 2.4% decline between July and August.

This article was posted on the First National webpage Here.

Please Note: The source of this article is from SherryCooper.com/category/articles/

Tiff Macklem and Jay Powell Are Emulating Paul Volcker–I Was Volcker’s Special Assistant.

Forty-Three Years Ago, I Was Fed Chair Paul Volcker’s Special Assistant

Inflation appears to be book-ending my career. I started my work as an economist in the Research Division of the Federal Reserve Board in Washington, D.C., in the late 1970s. Inflation had been trending higher for years. Neither Arthur Burns nor G. William Miller, the Fed chairmen preceding Volcker, had the fortitude to raise interest rates sufficiently and keep them there long enough to reduce inflation to a low sustainable pace. Paul Volcker pulled it off–for which he was personally vilified at the time. But since then, Paul Volcker has become a legend, esteemed as the central banker whose brute-force campaign subdued inflation for decades.

You can see in the chart below that in late 1979, the Volcker Fed hiked the overnight policy rate to levels well above the inflation rate and kept real interest rates (nominal rate minus inflation rate) positive for an extended period.

The current Fed Chair, Jay Powell, has expressed deep admiration for Paul Volcker, calling him “the greatest economic public servant of the era.” Last month, Powell alluded to his predecessor’s record of persistence, saying that policymakers “will keep at it until the job is done” — invoking Volcker’s memoir, “Keeping at It.”

The Bank of Canada was no slouch on the inflation front as well. As the chart shows, the Bank hiked interest rates in lockstep with the Fed in the Volcker years and even more in the early 1990s when Ottawa was fighting Canadian budgetary red ink to the ground.

This time around, Tiff Macklem has been ahead of the Fed in hiking interest rates and, in a speech on Thursday, said that the economy is still “clearly” in excess demand, with businesses facing an extremely tight labour market, wage gains broadening and underlying inflation pressures showing no signs of letting up. Macklem said that the sources of inflation, which started with goods prices, are broadening to the service sector. “. Labour markets remain very tight. Job vacancies have eased a little in recent months but remain exceptionally high. Our business surveys report widespread labour shortages. And wage growth has risen and continues to broaden.”

“With demand running ahead of supply, competition is posing less of a restraint on price increases, and businesses are passing through higher input costs more quickly. As a result, higher energy and material costs are showing up in the prices of a growing list of goods and services. So even if there is some relief at the gas pumps, price pressures remain high and continue to broaden. In August, the prices of more than three-quarters of the goods and services that make up the CPI were rising faster than 3%.”

Macklem continued, “As we look for a more fundamental turning point in inflation, measures of core inflation are becoming increasingly relevant…after taking out volatile components in the CPI that don’t reflect generalized changes in prices, inflation is running about 5%. That’s too high. We can also see that our core measures have yet to decline meaningfully even though total CPI inflation has come down in the last couple of months. Going forward, we will be watching our measures of core inflation closely for clear evidence of a turning point in underlying inflation.” In conclusion, the governor said, “there is more to be done….We know we are still a long way from the 2% target. We know it will take some time to get there. We also know there could be setbacks along the way, and we can’t afford to let high inflation become entrenched”.

So given the clear statements by the Fed and the Bank of Canada, it makes no sense why Bay Street economists are betting that the overnight rate in Canada will peak at around 4% by yearend. They are still forecasting a decline in short-term interest rates next year due to a slowdown in economic activity. I don’t buy that.

There are many views on how far the central banks will have to hike rates from here, but the critical issue is to reach a point where rates are meaningfully restrictive. A rule of thumb is that the overnight policy rate must rise to exceed the inflation rate. Fed Chairman Powell has said that he believes that real interest rates should be positive across the yield curve. Today, long and short US rates are still the lowest compared to inflation since the Burns era in the mid-1970s. (see chart below). Traders are betting that the US overnight rate will rise another 125 basis points (bps) by yearend and continue to rise next year to a median estimate of 4.6%.

Chair Powell has clarified that he is willing to tolerate much slower growth. As Bloomberg economists suggest, “Canada is seen having both faster growth and lower interest rates over the next three years — a peculiar mix of economic outcomes that assumes the country is more buffered from global headwinds — including a potential US recession — but won’t face the same pressure to match the Fed higher.”

Short-term money markets are betting the Bank of Canada will stop its hiking cycle at about 4%, versus a Fed benchmark rate peaking at about 4.6% and remaining below US short-term rates for at least another three years.

This is especially unreasonable given the fall in the Canadian dollar, which is now trading at US$0.728 compared to US$0.814 one year ago. This depreciation reflects the inordinate strength of the US dollar–the global safe-haven currency in a time of enormous uncertainty and volatility. The Canadian dollar has fared far better than other G-7 countries over this period. But the decline in our currency will raise the prices of the many US products and services we import, adding to inflation.

Inverted Yield Curves

In Canada and the US, 2-year yields have risen sharply to levels well above 5-year yields. As of October 6, the 2-year Government of Canada bond yield is at 4.0% compared to the 5-year yield at 3.49% and the 10-year yield at 3.31%. This implies the markets expect a slowdown in economic activity, but that does not mean that the overnight policy rate will fall in 2023 as Bay Street expects, especially if core inflation remains well above 2%. The Canadian prime rate is currently 5.45%, well above the 5-year yield of 3.49%. When the Bank of Canada Governing Council meets again on October 26, it will likely raise the policy rate by at least 50 bps to 3.75%, taking the prime rate up to 5.95% or higher—clearly improving the relative attractiveness of fixed-rate mortgage loans.

Bottom Line

For most of my readers, inflation is a brand-new experience, and so are rising interest rates. Inflation in Canada was at 2.2% when the pandemic began, and the 5-year bond yield was a mere 1.3%. Quickly the central bank cut the overnight rate from 1.75% to 0.25%, the prime rate fell from 3.95% to 2.45%, and the 5-year bond yield fell to a low of about 0.32%. Housing demand exploded and continued strong until it peaked in February 2022 when the Bank of Canada began to hike interest rates.

Interest rates will not fall to pre-pandemic levels next year or even the year after. And we will likely never see interest rates at pandemic levels again, at least I hope not, because it would take another global economic shutdown. Hence, mortgage-borrower psychology will change. Many more homeowners will choose to lock in fixed interest rates, and by the time this is over, a new generation will realize that interest rates don’t just fall but sometimes rise to levels higher than expected and stay there longer than expected—a painful lesson to learn.

Inflation Cooled Again in August, But Higher Rates Still Coming

Canada’s headline inflation rate cooled again in August, even a bit more than expected. The consumer price index rose 7.0% from a year ago, down from 7.6% in July and a forty-year high of 8.1% in June, mainly on the back of lower gasoline prices.

The CPI fell 0.3% in August, the most significant monthly decline since the early months of the COVID-19 pandemic. On a seasonally adjusted monthly basis, the CPI was up 0.1%, the smallest gain since December 2020. The monthly gas price decline in August compared with July mainly stemmed from higher global production by oil-producing countries. According to data from Natural Resources Canada, refining margins also fell from higher levels in July.Transportation (+10.3%) and shelter (+6.6%) prices drove the deceleration in consumer prices in August. Moderating the slowing in prices were sustained higher prices for groceries, as prices for food purchased from stores (+10.8%) rose at the fastest pace since August 1981 (+11.9%).

Price growth for goods and services both slowed on a year-over-year basis in August. As non-durable goods (+10.8%) decelerated due to lower prices at the pump, services associated with travel and shelter services contributed the most to the slowdown in service prices (+5.5%). Prices for durable goods (+6.0%), such as passenger vehicles and appliances, also cooled in August.

In August, the average hourly wages rose 5.4% on a year-over-year basis, meaning that, on average, prices rose faster than wages. Although Canadians experienced a decline in purchasing power, the gap was smaller than in July.

Core inflation–which excludes food and energy prices–also decelerated but remains far too high for the Bank of Canada’s comfort.  The central bank analyzes three measures of core inflation (see the chart below). The average of the central bank’s three key measures dropped to 5.23% from a revised 5.43% in July, a record high. The Bank aims to return these measures to their 2% target.

Bottom Line

Price pressures might have peaked, but today’s data release will not derail the central bank’s intention to raise rates further. Markets expect another rate hike in late October when the Governing Council of the Bank of Canada meets again. But further moves are likely to be smaller than the 75 bps-hikes of the past summer.

There is still more than a month of data before the October 25th decision date. The September employment report (released on October 7) and the September CPI (October 19) will be critical to the Bank’s decision. Right now, we expect a 50-bps hike next month.

Housing Soften Again in August

The full effects of the most recent rate hikes have not yet manifested. Statistics released today by the Canadian Real Estate Association (CREA) show that the slowdown that began in March in response to higher interest rates continued in August, albeit at a slower pace. Home sales recorded over Canadian MLS® Systems fell by 1.0% between July and August 2022. The pace of home sales last month was well below its 10-year moving average as buyers and sellers moved to the sidelines in response to rising mortgage rates and a reassessment of the outlook. While this was the sixth consecutive month-over-month decline in housing activity, it was also the smallest of the six.

It was close to an even split between the number of markets where sales were up and those where sales were down. Gains were led by the Greater Toronto Area (GTA) and a large regional mix of other Ontario markets. These were offset by Greater Vancouver, Calgary, Edmonton, Winnipeg, and Halifax-Dartmouth declines.

The actual (not seasonally adjusted) number of transactions in August 2022 came in 24.7% below the same month last year. While still a large decline, it was smaller than the 29.4% year-over-year drop recorded in July.

While some suggest that the worst of the housing correction might be behind us, recent data suggests that those sentiments are premature. The August inflation data for the U.S., released this past Tuesday, were considerably stronger than expected, especially for inflation excluding energy. To be sure, commodity prices have fallen sharply in recent weeks, tempering headline inflation. But many other components of core inflation have proven to be very sticky. In consequence, market-driven interest rates have risen further, and next week it is widely expected that the Fed will hike the overnight rate by at least 75 bps.

In Canada, we will see the August CPI data next Tuesday. The Bank of Canada aims to hike the policy rate target when it meets again on October 25. In the past, it took overnight rates above the inflation rate to finally break the back of inflation. Bay Street has been revising up its estimates for the terminal policy rate target all week. I believe it will be well above 4.0%.

New Listings

Sellers are reticent to accept that the sky-high prices posted early this year are no longer clearing markets. Rather than rapid-fire turnover, newly listed properties remain on the market for much longer,  multiple-bidding situations are rare, and many successful buyers are adding financing conditions to their offers.

The number of newly listed homes fell to 5.4% on a month-over-month basis in August. This built on the 5.9% decline noted in July, as some sellers appear content to stay on the sidelines until more buyers are ready to get back into the market. The decline in new supply was broad-based, with listings decreasing in about 80% of local markets, including every large market except for Montreal, where new supply was mostly flat from July to August.

With sales little changed and new listings down in August, the sales-to-new listings ratio tightened to 54.5% compared to 52.1% in July. The August 2022 reading for the national sales-to-new listings ratio was very close to its long-term average of 55.1%.

There were 3.5 months of inventory on a national basis at the end of August 2022, up slightly from 3.4 months at the end of July. While the number of months of inventory remains well below the long-term average of about five months, it is also up quite a bit from the all-time low of 1.7 months set at the beginning of 2022.

Home Prices

The Aggregate Composite MLS® Home Price Index (HPI) edged down 1.6% on a month-over-month basis in August 2022, not a small decline historically, but smaller than in June and July.

Breaking it down regionally, most of the monthly declines in recent months have been in markets across Ontario and, to a lesser extent, in British Columbia; however, in August, Ontario markets contributed most to the overall national decline.

Looking across the Prairies, prices in Alberta appear to have peaked. Prices still rise slightly in Saskatchewan, while Manitoba recorded the only decline. In Quebec, prices have dipped somewhat in the last couple of months. On the East coast, the softening of prices confined to Halifax-Dartmouth is now also appearing in New Brunswick, Newfoundland and Labrador. By contrast, prices in PEI continue to edge ahead on a month-over-month basis.

The non-seasonally adjusted Aggregate Composite MLS® HPI was still up by 7.1% on a year-over-year basis in August. This was the first single-digit increase in almost two years, as year-over-year comparisons have been winding down at a brisk pace from the near-30% record year-over-year gains logged just six months ago.

Bottom Line

The Canadian housing correction continues as the Bank of Canada aggressively tightens monetary policy. Using average benchmark prices by region, the first table above shows how much prices have fallen since their recent peak in March this year. For Canada, average prices have dipped 11.1%, led by the 13.7% decline in Greater Toronto. Greater Vancouver has posted an 11.7% drop. The second table shows that, despite these downdrafts, year-over-year price gains remain positive, reflecting the super-charged home price inflation from August 2021 to March 2022.

By the end of the first quarter of 2023, all the y/y appreciation will be obliterated. The 50% rise in home prices over the first two years of the pandemic was fuelled by record-low interest rates. The overnight rate was a mere 25 bps. It will soon be 400 bps. No wonder recent variable-rate mortgage buyers are beginning to confront their trigger points.

Job Market Weakens As Economy Slows

The August employment report, released this morning by Statistics Canada, was considerably weaker than expected. Higher interest rates have slowed the red-hot labour market. The Canadian economy shed 39,700  jobs in August, missing market expectations of a 15,000 rise and bringing cumulative declines since May 2022 to 113,500 (see chart below). The job losses were most significant in education and construction. Education employment in the summer months can be distorted by seasonal factors and changes in the start of the school year.

We know that residential construction projects have been postponed or cancelled owing to the rise in borrowing costs and the slowdown in home sales. There were also fewer workers in construction (-28,000; -1.8%) in August, with the decrease spread across several provinces, led by Alberta (-11,000; -4.6%) and Ontario (-10,000; -1.6%).Total employment fell in British Columbia, Manitoba, and Nova Scotia, while it increased in Quebec. There was little change in the other provinces.

Total hours worked were unchanged in August, following a decline in July (-0.5%). On a year-over-year basis, total hours worked were up 3.7%.

Hybrid Work Continues

Working from home continues to be an important feature of work for many Canadians, although the specific nature of the arrangement continues to shift. As of August, 16.8% of employed Canadians reported that they usually work exclusively from home, down from 18.0% in July and down 7.5 percentage points since the beginning of 2022. The proportion of workers with a hybrid work arrangement—those who usually work both at home and at locations other than home—increased by 0.7 percentage points to 8.6% in August.

The Unemployment Surged From Record Low

The unemployment rate was 5.4% in August, up 0.5 percentage points from the record low of 4.9% observed in June and July. This was the first increase not coinciding with a tightening of public health restrictions since May 2020, when the unemployment rate reached its pandemic peak.

The unemployment rate increased for four of the six main demographic groups in August, including young men aged 15 to 24 (+1.2 percentage points, to 11.0%); women aged 55 and older (+0.7 percentage points, to 5.2%); core-aged men (+0.6 percentage points, to 4.6%); and core-aged women (+0.4 percentage points, to 4.5%). It was little changed among young women and older men.

The adjusted unemployment rate—which includes people who wanted a job but did not look for one—rose 0.5 percentage points to 7.3% in August. This increase was largely due to the rise in the number of unemployed rather than an increase in those who were outside the labour force but wanted work.

The hope is that the rising number of unemployed Canadians will help to fill the record job vacancies.

WAGE INFLATION ACCELERATES TO 5.4% IN AUGUST

Particularly troubling for the Bank of Canada is the further acceleration in average hourly wages, which rose 5.4% on a year-over-year basis in August, compared with 5.2% in June and July (not seasonally adjusted).

Bottom Line

The Bank of Canada will welcome the cooling labour market, which will ultimately take the pressure off wage inflation. I don’t expect today’s weaker jobs report to change the Bank’s view that interest rates need to rise further in the coming months to return inflation to its 2% target level.

Bloomberg News reported that despite the rise of mortgage rates heightening “the risk of a correction that could affect asset valuations and repayments” for Canadians, Peter Routledge, the Superintendent of Financial Institutions,  said the Office of the Superintendent of Financial Institutions (OSFI) would not adjust the standards in B-20.

OSFI first created its Residential Mortgage Underwriting Practices and Procedures Guideline (B-20) in 2012. The guideline set expectations for residential mortgage underwriting for federally regulated lenders.

“The uncertainty and anxiety caused by a rising interest rate environment have, understandably, caused some Canadians to advocate for a loosening of the underwriting standards in Guideline B-20,” Routledge said.

“Let me reassure those of you who oppose a loosening of underwriting standards that OSFI will not do that.”

In June, Canada’s banking regulator announced that it tightened underwriting standards on combined loan plans such as reverse mortgages, mortgages with shared equity features and combined loan plans.

Routledge reiterated that OSFI is “constantly evaluating the MQR (Minimum Qualifying Rate) to measure its efficacy in sustaining sound residential mortgage underwriting.”

“Because Guideline B-20 touches home ownership, it gets an extraordinary amount of public attention – at least relative to all our other regulatory guidelines,” Routledge said.

“We accept this reality – housing is crucial to all Canadians, and Guideline B-20, whether we at OSFI like it or not, matters to Canadians. And so, our job is to address concerns with B-20 transparently and forthrightly.”