Time for a Big Summer Market Update

September 1, 2023

You’re on a plane, currently descending gradually through the clouds.  I’m on the plane, too.  In fact, everyone in the country is onboard. Welcome to Flight 2023 of Canadian Economy Airlines.  We know our destination: A normal rate of inflation. What we don’t know is how long the flight will take…nor what kind of landing to expect when we get there.

Will it be a hard landing, or a soft one?

This metaphor, silly as it is, accurately describes the central economic problem of the year: How to bring historically high prices down without also tanking the economy (In other words, how to land the plane without crashing it).  It’s a puzzle that has plagued every economist who has ever sat in the cockpit during times of high inflation.  

In this message, I want to give you an update as to where we are on our trip.

The Flight So Far

If you’re one of those people who can actually sleep on a plane – lucky you – then here’s a recap of what happened while you were out.  In 2022, coming on the heels of a global pandemic, a global reopening, and a war in Europe, inflation in Canada peaked at 8.1%[1](6.3% if you exclude energy prices). If you rewind back to the beginning of this year, prices fell but were still elevated at 5.8%. This was partially achieved by higher interest rates, which had risen to 4.25% in January [2].

At the time, it was widely expected among economists that the Bank of Canada would continue hiking rates to bring inflation down…but as a result, the economy could enter a recession sometime later in the year (this would be the aforementioned hard landing). Now, over eight months into 2023, we can say that the first part of the prediction held up. The BoC has continued raising rates, albeit at a slower pace, with rates currently sitting at 5%. Consumer prices have cooled, too, with the most recent data showing inflation down to 3.3%.

The second half of the prediction, however, is yet to come true. The Canadian economy grew by 0.8% in the first quarter [3].And while the economy may have contracted slightly over the summer, we still have not seen the two straight quarters of negative growth necessary to declare a recession. So, over the summer, many of the same experts that were forecasting a recession began revising their predictions.  Maybe, they say, we’ll avoid a recession this year.  Maybe it is possible to bring down inflation without tanking the economy. Maybe we can land this bird softly after all.  

Soft Landings vs Hard Landings

This is an important issue to ponder. How investors expect the landing to go plays an important role in how the markets perform. But to accurately think about the issue, we have to first understand what the difference is…and why it’s so hard to know which we’re in for.

First, let’s define these two terms. A soft landing is when inflation decreases to an acceptable rate without triggering an unacceptable rise in unemployment.A hard landing, by contrast, is when prices come down so fast that most businesses experience a major drop in revenue, causing them to lay off workers.This would result in a surge in unemployment. Since unemployed people tend to spend less money, the economy would contract. When an economy contracts long enough – two straight quarters is a common measurement – we call it a recession.

Do you see why the plane analogy is actually a good one? When pilots land a plane, they must do so quickly enough to prevent stalling, but gradually enough to glide parallel to the ground, kissing the runway rather than slamming into it.That’s the goal, here, too. Inflation has to decline quick enough to overcome inertia, but not so fast the economy crashes.

The institution most responsible for doing this – the pilot in our metaphor – is the Bank of Canada. The Bank’s principal role is “to promote the economic and financial welfare of Canada” [4].To do this, the Bank is tasked with helping to keep prices low, stable, and predictable. But that can be difficult to do, especially when inflation surges upward in a relatively short amount of time. When this happens, the Bank is forced to hike interest rates to cool off the economy so that businesses have no choice but to lower prices. It definitely works, but it’s risky. Raise rates too high, too fast, and you drive the economy into a full-blown recession.

Mindful of this, the Bank has been raising rates much more gently and gradually. The result is a very slow return to normal prices, but – so far at least –continued economic growth.

So, a soft landing, right?

Well, not so fast. First of all, the plane hasn’t landed yet. Second of all, there’s no firm agreement as to what a landing actually is. How low does inflation have to get before we declare touchdown? The Bank of Canada typically aims to keep medium-term inflation around 2%, with a control range of one to three percent [5]. And how much is unemployment permitted to rise? Six percent? Seven? Higher? Actually, here’s a thought experiment for you: What if, over the next twelve months, unemployment and inflation both stay where they’re currently at? Is that a soft landing, or a hard one? Or is it no landing at all?

You can see why nothing keeps an economist up at night so much as inflation. It’s not a clear-cut issue; and we haven’t even gotten into more nuanced topics, like what to actually measure when calculating inflation, whether the raw unemployment rate is really the best barometer of economic health, or the role consumer sentiment plays in all this.

In my opinion, however, it’s still too early to proclaim a soft landing. That’s because there are still potential patches of rough air ahead. For one thing, while inflation is definitely cooling, it actually ticked up in July (inJune it was at 2.8%). For this reason, another rate hike might still be in the cards. And while the economy has avoided a recession thus far, the pace of added jobs and economic growth is slowing. So, the numbers we’re seeing now might not be quite as rosy in the future.

For now, though, inflation is cooling down, the economy is not in a recession, and the Bank’s rate hikes are coming fewer and farther between. This is good news! And it’s a major reason why the markets are up modestly so far this year. Should these factors continue in a positive direction, it’s perfectly reasonable to hope for a smooth final leg of our flight.

WhatThis All Means For Us

Whew!We got really wonky in this message, didn’t we? But I wanted to make sure you got an up-to-date view of the situation. As the co-pilot on your financial journey, here’s my view. While the year has been positive, it’s possible that a “landing,” whether hard or soft, is still far away. Right now, we’re in a low-altitude glide. Therefore, the message from the cockpit is this: Feel free to move about the cabin, but for now, it may be best to keep the seat belt sign on.

In the meantime, my team and I will keep doing all we can to help you continue moving forward. Please let me know if you ever have any questions or concerns – and enjoy the rest of your flight!

[1] “12-month change in the Consumer Price Index,” Statistics Canada, https://www150.statcan.gc.ca/n1/daily­quotidien/230815/cg-a001-eng.htm

[2] “Canadian interest rates,” Bank of Canada, Canadian interest rates and monetary policy variables: 10-year lookup - Bank of Canada

[3] “Gross DomesticProduct, first quarter 2023,” Statistics Canada, https://www150.statcan.gc.ca/n1/daily­quotidien/230531/dq230531a-eng.htm

[4] “Institutional Framework,” Bank for International Settlements, https://www.bis.org/mc/currency_areas/ca.htm

[5] “Inflation: Definitions, graphs, and data,” Bank of Canada, https://www.bankofcanada.ca/rates/indicators/capacity-and­inflation-pressures/inflation/

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