A Worrying Mix of High Inflation and Slowing Growth
This year has been marked by significant macroeconomic and market uncertainty. Equity and bond markets have yo-yoed and important macroeconomic indicators are mixed. The combination of pandemic era fiscal and monetary stimulus, the overlapping impacts of COVID and Russia/Ukraine crisis-related supply challenges have led to a considerable run-up in consumer prices and market volatility. The issue of high inflation has affected markets negatively and is beginning to weigh on economic growth. Even though labour markets remain seemingly healthy, the run-up in prices and market volatility could push unemployment higher and shove the economy into recession. This could trigger what is commonly known as stagflation.
In this article, we present three macroeconomic scenarios in which the issue of stagflation plays out. Each scenario has an assigned probability or likelihood that convey qualitative assessments.
Baseline View: Mild Stagflation
Our baseline view is one of mild stagflation. That is, inflation keeps rising and is above central bank targets despite interest rate decisions. In this case, inflation joins forces with higher rates to weaken demand and shrinking demand would cause the economy to slow down materially. In this scenario, real gross domestic product (GDP), or economic growth would not land in negative territory.
Our baseline view is that supply chain constraints subject to the notions of COVID-related lockdowns or commodity-related shocks remain the main source of inflationary pressure, not solely the effects of current monetary policy. And while goods-related inflation may slowly dissipate in the next few years, it may be replaced by wage and service inflation. These new cost pressures would affect the unemployment rate negatively.
Greater price and wage pressures, and higher rates of unemployment would eventually lead to lower growth. Looking at forward-looking indicators, consumer stress is inching higher month over month. This is the result of higher food and energy prices, mortgage rates and housing costs. These factors do not impact low, middle and high-income households to the same extent. However, collectively, they contribute to harm overall consumer confidence and could cut into consumer spending and housing, two of the most important economic growth drivers in North America. The result would be a drop in economic growth.
A stagflationary environment is our baseline view over the next year or so. This view is underpinned by both shorter-term and medium-term drivers like consumer prices, household spending and cost of housing.
Pessimistic View: Shallow Recession
In contrast to our baseline scenario, there is also a potentially more serious economic outcome: a shallow recession. Our pessimistic scenario is one where inflation is uncontrolled and central banks are forced to brake hard, driving the economy into a shallow recession. In other words, central banks could squeeze the economy swiftly and aggressively while trying to bring inflation under control.
Currently, inflation in North America is running hot. While the growth of the Canadian and U.S. consumer price index (CPI) has slowed in recent months — 7.7% and 8.3% respectively in August — price pressures are still hotter than economists’ expectations and central bank targets (1-3%). As a result, some analysts are predicting sizeable interest rate increases over the next few months. This accelerated process of short, aggressive rate hikes and high inflation itself could trip us into recession.
The Canadian economy is particularly sensitive to interest rates, given the significance of the housing market. The latest rate hike in July forced five-year mortgages rates to jump over 5%, a rate not seen in more than a decade.
Now, the Bank of Canada is forecasting housing investment to plunge in 2023 and the consensus is now aiming for a reprieve in commodity prices. Altogether, this will negatively affect national gross domestic income and increase the likelihood of a shallow recession. This takes place at a time when most households are reluctant to dip into excess savings any further. There is a silver lining — the labour market is still on a tear, but for how long?
Overall, shallow recession risk is being priced to some extent by one of the most historically effective recession leading indicators like Canada’s inverted yield curve (i.e. long-term interest rates are below short-term rates). This suggests that the market is becoming more pessimistic about the economic prospects for the near future and that a recession is becoming more likely.
Optimistic View: Soft Landing
Still, there is an optimistic scenario in which central banks successfully navigate inflationary pressures and guide the economy towards a soft landing. However, the likelihood of this scenario transpiring is low.
As previously mentioned, inflation is proving to be more persistent than projected. Recent inflation reports show this. This is triggering central banks to engineer a period of “below-potential growth” via higher interest rates. The markets are now grappling with the prospect of stagflation or even a recession as central banks are committed to their fight against inflation. Even the Bank of England expects the U.K. to be in recession for the whole of 2023.
Since 1955, there has never been a quarter with average inflation above 4% and unemployment below 5% (where the U.S. and Canada stand today) that was not followed by a recession within the next two years. That’s according to a U.S. study released in April by the former U.S. Treasury Secretary and Harvard University professor Larry Summers. In addition, historical instances of soft landings in the U.S. (1965, 1984 and 1994), show that labour market conditions were very different from today and were without the impact of supply shocks that still plague the global economy today. Like Summers, we view a “soft landing” as unlikely over the next year or two.
As all three scenarios show that there are a host of factors pointing to continued elevated inflation in the coming quarters. It’s certain that central banks will want to maintain the credibility of their price stability mandate at almost any cost. This could result in a near certain mild stagflation environment. But, should central bankers truly want to remove inflationary excess liquidity in the financial system and take policy rates beyond ‘neutral’, then a shallow recession might be in the offing.
This article contains forward-looking statements with respect to economic conditions. Such statements address future events and conditions, and therefore involve inherent risks and uncertainties. Although AIMCo believes that the expectations and assumptions on which the forward-looking statements are based are reasonable, AIMCo can give no assurance that such statements will prove to be correct. Accordingly, AIMCo disclaims any and all responsibility for the continued truth of such statements at any future date.
This article is of a general nature only and does not purport to take into account all considerations that may be relevant to any particular individual or organization. As such, this article is not intended to be, nor should it be construed to be, investment advice to any particular individual or organization.