Douglas Porter

March 18, 2022

The above title conjures up the threat of another R word, and it’s not reprieve, resolution, or relaxation. Yet, even amid all the clear and present risks to the growth outlook, financial markets mostly steamed ahead this week. Yields surged again, stocks rebounded, and oil bounced back above $100 after a sharp drop at the start of the week. The equity comeback may be the most notable move; after dropping 13% in the space of just 10 weeks and moving into the so-called death cross, the S&P 500 promptly reeled off a 5% bounce. Given current global circumstances, it may be almost unseemly to point out that the TSX hit an all-time high on Thursday, and is up 5% since the invasion began.

Despite this week’s equity market rally, there is little doubt that downside risks to growth are mounting. We listed in last week’s missive five major growth drags arising from the conflict—more inflation, supply chain snarls, the hit to confidence from the war, sanctions, and weaker financial conditions. (The threat of more disruptions to supply chains has been amped up further by lockdowns in key industrial areas of China.) The financial conditions factor was mitigated somewhat by this week’s rebound in risk assets, but there’s still the matter that bond yields are grinding higher again. After a brief dip at the onset of the invasion, the 10-year Treasury yield has reversed course and is now up about 15 bps since the war began to levels not seen in nearly three years. The upswing in Canadian yields has been even more abrupt, again pushing above Treasuries after a rarely interrupted run of negative spreads in the past nine years.

The entire yield curve shifted higher this week, flattening somewhat, with part of the climb both before and after the Fed’s 25 bp rate hike on Wednesday. While most of the proceedings went on script, the FOMC still managed to deliver a hawkish surprise with a massive upgrade in their rate expectations. The median projection for the overnight rate by the end of 2022 jumped a full 100 bps since the December meeting, essentially a 25 bp rate hike at every meeting through the rest of this year. While the dot plot is often derided, it should be viewed as conditional on the FOMC’s current economic forecast (which is still quite upbeat), and does contain a useful insight into members’ views. And those views can be summed up as “wow, we really missed the boat on the inflation call, and we better get cracking”—to use the technical terms. Chair Powell reinforced that message in the press conference, all but admitting the Fed had erred by waiting too long to start tightening.

The large advance in the Fed’s rate projections can also be seen as a signal of their determination to deal with what’s clearly an unacceptable inflation backdrop. With the Fed’s newfound inflation-fighting zeal, and their view that the economy can handle what’s coming, we are bumping up our forecast on rate hikes through the rest of the year. We have lifted total Fed rate hikes this year to 175 bps (up 50 bps) and to 150 bps (up 25 bps) by the Bank of Canada. While this implies a steady stream of 25 bp moves at almost every meeting (the BoC would skip one), things may not play out quite that neat and tidy—50 bp hikes remain a distinct possibility, especially for the Fed—but so, too, are occasional pauses, depending on how geopolitical events unfold, and how markets respond to both conflict and aggressive tightening.

Whither the economy in this environment? Even as the FOMC marked down their GDP projections for 2022, we believe they are still too optimistic on growth, and too low on inflation. From a rates perspective, those two forces almost balance out, which is how/why we migrate to roughly the same point by the end of this year. Clearly, there are serious downside risks to the growth outlook, but there are also obvious high-side risks to our high-side of consensus inflation call as well. The latest consensus survey, conducted earlier this week, reveals a notable marking down of growth in the past month amid a notable marking up of inflation. But, in both cases, we believe there’s more marking ahead. On growth, the consensus now looks for the U.S. economy to expand 3.3% this year, down from 3.7% a month ago (i.e., before the conflict), but still above our 3% call.

The change in the inflation outlook has been even more dramatic, and yet is still trailing events. Consensus now expects U.S. CPI to rise by an average of 6.6% this year, up a hefty 1.4 ppts in a month from 5.2% before the war. But that’s well behind our call of 7.5%, and the current pace of 7.9%. Just to give a sense of how massively the inflation outlook has evolved, consensus was at just 4.2% for 2022 inflation three months ago (or around the time the Fed last provided a dot plot and economic forecast), and it was just 2.2% a year ago. That huge miss should serve as a stark reminder that the Fed is not the only forecaster to have gone astray in the past year.

It’s a broadly similar picture for Canada, albeit less dramatic. Growth expectations for this year have only been nudged down by a tick in the past month to a still-strong 3.8% (we’re at 3.5%). That relative firmness reflects Canada’s status as a major exporter of many of the same products that Russia sells, almost all of which have lurched higher in the past month.

However, because the Canadian dollar has firmed only slightly amid this commodity surge—albeit with a hint of loonie strength this week to above 79 cents—Canada’s inflation outlook has moved up nearly in lockstep with the U.S. revisions. Consensus lifted average CPI by 1.4 ppts in the past month to 5.1%, although, again, that is still below our call of 5.5% and the latest reading of 5.7%. (The run-up in energy and food prices alone in March points to a test of the 6% threshold on inflation in next month’s report.) Not to embarrass fellow forecasters, but the latest inflation estimate stands in stark contrast to the consensus average for 2022 of just 3.3% three months ago and a mere 1.9% a year ago.

To summarize, the consensus view on the impact of the war, at least so far, is that U.S. growth will be cut 0.4 ppts this year and Canada by just 0.1 ppt (versus our revision of -0.5 ppts for both), while inflation has stepped up by a hefty 1.4 ppts in both countries. Note that consensus has taken an even bigger swipe at Europe, reasonably so, with the GDP estimate for 2022 cut by 0.7 ppts in the past month and inflation boosted by a hefty 1.8 ppts over that period. The bigger inflation impact reflects the drop in the euro (down nearly 3% in a month), and high and volatile natural gas prices on the continent.

While these forecast revisions are meaningful, the risks look larger to all of them. Even so, there are a number of factors to suggest that we are still some ways from the risk of an outright downturn in activity. First, growth had solid momentum heading into this episode. For example, U.S. housing starts, manufacturing, and even retail sales were robust in the opening months of the year. Second, there is still some re-opening growth impulse in the wings, with travel moving more towards ‘normal’, especially in Canada. Finally, households are still well-cushioned with excess savings for the ramp-up in prices. As but one example, even adjusting for the outsized inflation of the past year, real retail sales were up almost 6% y/y in Canada in January and a towering 9% y/y stateside in February.

Doug Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.