Inflation Concerns Dominate: Scotiabank’s Forecast Tables

• The failure of US banks is a concern and is adding significant uncertainty to the outlook. The market reaction to developments has been extreme and likely overblown. We do not think we are on the precipice of a broad financial crisis.

• These developments are almost certain to modestly weaken US and global economic growth and we have taken growth forecasts down accordingly. We remain of the view that a mild recession is the most likely outcome, but our conviction on this call is wavering.

• Inflation remains the dominant concern for the Federal Reserve and other central banks. We do not believe the challenges in the banking system will outweigh concerns about inflation control. We believe markets have dramatically over-reacted to recent developments and we continue to believe the Federal Reserve will raise rates by a combined 50 basis points at its next two meetings. We expect the US and Canadian central banks to cut rates in early 2024, in contrast to current pricing in markets.

The failures of Silicon Valley Bank and Signature Bank undoubtedly pose a material risk to the global outlook. Financial markets have responded dramatically, leading to a wild reassessment of the path of monetary policy in the US and Canada. In the US, for instance, markets went from pricing a nearly 6% terminal Federal Funds Rate later this year to a year-end rate of around 4% in the span of a few days. This of course reverberated through the yield curve, leading to a dramatic reduction in yields at all maturities. The risks of contagion are evident and there are reasons to be concerned, but the aggressive response by US policymakers that saw them guarantee all deposits in these banks and provide emergency liquidity assistance should quell risks of an additional deterioration. As Derek Holt noted, “It cannot be overstated how absolutely precedent setting” these actions are. As a result, we believe the dramatic re-pricing of rate expectations is very much overblown. We continue to expect additional rate increases of 25 bps by the Federal Reserve at its next two meetings, though we were admittedly leaning towards a 50bps move and a higher terminal value prior to the banks’ collapse.

The question at the heart of the rate calls is whether the impact of the failures will be of sufficient macroeconomic consequence to negate the impact of stronger than expected PCE inflation and a still robust jobs market in the US. We are shaving our US forecast to account for the uncertainty and demand impacts of these developments. The banking issue is almost certain to lead to reduced provision of credit. We now forecast US growth of around 1% this year and next and continue to believe a mild recession will begin in Q2. That recession is likely to be modestly deeper now than earlier forecast. Inflation is nevertheless forecast to be higher than in previous forecasts owing to readings thus far this year that cast doubt on the speed at which inflation will decline. The core personal consumption deflator accelerated sharply on a monthly basis in January, and February core CPI inflation accelerated as well. The stickiness in inflation seems to be related in part to the lagged impact of supplier delivery challenges as the inclusion of PMI supplier delivery times improves the performance of our US inflation forecasting methodology, as it does in our Canadian model.

Some argue that the failure of these banks is an indication that the Federal Reserve’s interest rate policy is leading to some unintended consequences that should prompt a reassessment of the stance of monetary policy. We disagree. In our view the challenges faced by these banks represents a fundamental failure of management in light of the evident direction that rates, and the yield curve have been on for more than a year now. The US continues to have an inflation problem that requires modest additional tightening. That concern should dominate other considerations, particularly given the scope of the measures laid out to contain the problems at the affected banks. The February US inflation print is a reminder that inflation continues to be a challenge in the US, and that the Federal Reserve’s job is not yet done. As a result, we continue to expect additional 25 basis points increases by the Fed at the next two meetings. We do not believe interest rates will be cut this year. Additional increases may be required beyond the 50bps we predict if inflation remains sticky at current levels, but as René Lalonde and Patrick Perrier estimate, the real policy rate should continue to increase throughout the year if inflation declines as generally expected.

In Canada, there is some evidence that the economy is slowing, but it remains mixed. Statistics Canada’s Real-Time Local Business Conditions Index shows a moderation of activity in early February though the job market continues to display remarkable strength in the first two months of the year. We remain of the view that Canada will experience a mild recession in Q2 and Q3, a view that is reinforced by the negative revision to US growth. In contrast to the US, some measures of core inflation in Canada point to a more noticeable cooling trend but we are raising our inflation forecast very modestly in Canada on account of stronger US inflation. This should still allow the Bank of Canada to keep its policy rate at 4.5% through the year, before gradually cutting rates through 2024. We expect the BoC policy rate will stand at 3% at end-2024. As noted, the real BoC policy rate will rise significantly as the year progresses despite our forecast of a flat nominal rate through the end of this year. The risks to this rate path are undoubtedly tilted to the upside in the next few months. If Canadian inflation begins to exhibit the same behaviour as US inflation since the beginning of the year, or if the economy does not slow as expected, Governor Macklem may need to raise rates further late Spring or early Summer. If that became a necessity, he would likely need to raise the policy by more than a simple 25bps move.