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Interest Rate Peak: Are We There Yet?

30 August 2023

Canadian homeowners grappling with rising prices and mounting mortgage payments want to know when central banks will stop raising interest rates. The labour market may provide a clue. 

US Outlook

US Federal Reserve chair Jerome Powell’s remarks at the recent  Jackson Hole Economic Symposium provide some insight into what central bankers are thinking. 

For the last 45 years, the Fed has invited central bankers, finance ministers, academics, and financial market participants from around the world to discuss economic issues facing the U.S. and other world economies. Federal Reserve Chairs have traditionally used this symposium as a forum for setting the tone for key monetary policy discussions. 

With market expectations split on a US rate hike before the end of the year, Powell delivered a balanced message with a view to leaving options open for committee members when they meet in September.

Key takeaways from his speech:

  • The Fed will remain data dependent, with future actions taken according to inflation and economic activity measures.
  • The Fed is trying not to make the same mistakes of the 1970s. If inflation continues to move lower and the economy continues to grow, monetary policy will remain unchanged for the foreseeable future, with inflation (well) above the Fed’s 2.0 percent goal. 
  • The Fed could tighten further if inflation stops declining, or if it accelerates again. Resilience in the economy comes with the risk of inflation reacceleration.

As of July, the annual rate of inflation in the US was 3.2%, well down from its peak of 9.1% in June of 2022, the highest level in four decades

Inflation has been a global phenomenon, but the global economy appears to be softening based on the most recent JPM Global Manufacturing Purchasing Managers’ Index. Only one-in-three economies (ten of the 30 economies for which data are available) reported an increase in output, and for half of those, the gains were marginal. Overall, price pressure has been receding, but further progress is required.

The Fed’s challenge is understanding the lagging effects of the pandemic on top of the lags associated with monetary policy. This is evident in the US labor market where 9.5 million job openings are keeping the unemployment rate low. As noted by the Fed, inflation is currently more responsive to labour market tightness than it has been for several decades.

The Phillips curve is an economic theory that highlights a trade-off between unemployment and inflation. It claims that with economic growth comes inflation, which should lead to more jobs and less unemployment – something that was observed during the inflationary period of the 1970s and 1980s. With inflation subdued from the mid-1990s until 2021, economists have debated whether the non-linear unemployment-inflation trade-off suggested by the Phillips curve still holds true in modern economies.

A different model of inflation dynamics is the New Keynesian Phillips curve (NKPC), which relates current inflation to current output and future inflation. It assumes that prices are ‘sticky’ and do not adjust instantly to changes in demand or costs. 

Some economists have suggested the surge in inflation in the 2020s can be explained by a nonlinear New Keynesian Phillips curve (NKPC). They believe the recent inflationary surge was the result of an exceptionally tight labour market. If that is true, their analysis suggests the “cost of taming inflation triggered by a labor shortage, but with stable inflation expectations, can be expected to be much lower than it was in the 1970s.” This implies that labour market dynamics are critical to how inflation unwinds in this market scenario.

Canadian Outlook

There is a similar story in Canada. The Bank of Canada has focused on the output gap, which measures the difference between an economy’s actual and potential output (gross domestic product, or GDP), to determine how inflation is trending. When the output gap is positive—when actual output is higher than potential—the economy is operating above its sustainable capacity and is likely to generate inflation. 

Potential output is the maximum amount of goods and services an economy can produce when operating at full capacity (i.e. at full employment and utilizing all of its resources). While potential cannot be observed, it can be estimated. The Bank of Canada relies on these estimates in its policy setting.

Projecting potential GDP in the wake of the pandemic has been particularly difficult because it is likely that potential GDP has itself been affected, at least temporarily. Many businesses were closed, workers have left the labor force, and employee-employer relationships have severed, so it may be some time before the productive capacity of the economy returns to where it would have been without the pandemic. As a result, potential GDP has not been a stable guidepost for the Bank.

Instead, the Bank has been focused on the labour market – unemployment, job vacancies and wages –  to determine if labour has been in excess demand or supply. While the Bank has not yet looked at whether unemployment needs to be higher to hit its inflation targets, we can get a sense of this by looking at the non-accelerating inflation rate of unemployment, or NAIRU, which is the lowest jobless rate that won’t accelerate inflation. In other words, if unemployment is at the NAIRU level, inflation is constant. 

While the Bank of Canada has not published a NAIRU estimate, CIBC recently estimated a NAIRU rate of 5.7% is consistent with stable inflation in the final years of the prior cycle (1997-2019). They note that job vacancies have been persistently higher during this current cycle; however, this source of potential wage pressure has been subsiding. The current job vacancy rate is close to its 3% pre-pandemic rate.

CIBC’s view is that “[a} couple more quarters of soft job gains and an upward creep in unemployment rate should do the trick, or perhaps even less if job vacancies further ease and help cool wage pressures.”

In summary, look to the labour market if you want to understand if the Fed and Bank of Canada have finished raising rates.


Independent Opinion

The views and opinions expressed in this publication are solely and independently those of the author and do not necessarily reflect the views and opinions of any person or organization in any way affiliated with the author including, without limitation, any current or past employers of the author. While reasonable effort was taken to ensure the information and analysis in this publication is accurate, it has been prepared solely for general informational purposes. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author. There are no warranties or representations being provided with respect to the accuracy and completeness of the content in this publication. Nothing in this publication should be construed as providing professional advice including investment advice on the matters discussed. The author does not assume any liability arising from any form of reliance on this publication. Readers are cautioned to always seek independent professional advice from a qualified professional before making any investment decisions.

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