"Like a coiled spring"

“Like a coiled spring”: Deputy Chief Economist Michael Gregory offers his perspectives on the North American economy

 

Posted On: June 24, 2021
Topic: Reports and Insights

 

Michael, in a recent meeting of the bank's Senior Leaders, Darryl White likened the North American economy to a "coiled spring" – a colourful way of saying there is a massive amount of pent-up demand just waiting to be released. What's your take?

I think that's absolutely the case. U.S. Federal Reserve chair Jerome Powell referred to it as "an anticipated burst of spending". We've already had a pretty healthy rebound in spending on goods, but a recovery is still to come on the services side and that's the biggest part of the economy. That being said, demand for services is trickier to anticipate than demand for goods. I may delay buying a new car when the economy is bad, then make the purchase when things pick up again. But if I usually take a couple of vacations a year, and then I can't travel for two years, will I take six vacations the year things open up? Probably not. However, I may be prepared to pay more for the vacations I do take.

For the first time in many years, inflation is a subject of concern. Should we be worried?

We are seeing inflationary pressure as demand pushes up against constrained supply. We are also seeing higher prices for oil and food, and record prices for non-energy commodities that are key exports for Canada. So as this continues, we may see businesses pass along those higher prices, which will lead to inflation. Central banks are telling us not to worry, because unless you have compensating wage gains, higher prices eventually choke off demand. But remember – hundreds of billions of dollars have been pumped into Canadian households, and two trillion in the U.S. There is a massive amount of excess savings out there, and we believe people will be willing to pay high prices for longer than central banks are anticipating. If labour markets tighten and wage inflation starts to heat up, that inflationary pressure could become persistent.

How will this affect interest rates?

Several months ago, we forecasted that interest rates would begin to rise in early 2024. Now we've pulled that prediction forward to some time in early 2023. I wouldn't be surprised if it slips into 2022.

We've been at record low interest rates for many years. Are you seeing a return to historical norms?

No, there are still powerful secular forces keeping inflation at bay. An aging population is inherently disinflationary. So is technological innovation – just think about the disruption in pricing caused by companies like Amazon, Uber and AirBnb. These forces should contribute to interest rates remaining lower than historical averages. Over the medium term, we believe the U.S. Federal Reserve will aim for a neutral interest rate (the rate that supports maximum economic output with a constant rate of inflation) of two per cent, and the Bank of Canada slightly less than that.

Are you seeing different outlooks for Canada and the U.S., or are the two economies heading in roughly the same direction?

Canada's pandemic restrictions have been more onerous, and our vaccine roll-out – which is critical to the reopening of our economies – has been slower, at least initially. Even so, Canada and the U.S. grew at roughly comparable rates in Q1 because Canada had some tailwinds from rising commodity prices. However, in the second quarter the U.S. economy really started to really accelerate. On June 15, California – the largest state economy – got rid of all restrictions. New York City has done the same. So as Canada re-opens gradually, the U.S. is moving full speed ahead. Once Canada is fully open for business our economy will explode, and I think we'll do better than the U.S. in the last half of the year because of the "coiled spring effect" that Darryl mentioned.

Stocks have been on fire this year. What's your current read on the markets?

The current super-low interest rates are encouraging people to take more risk in all asset classes, and that's driving up prices. In some cases, those price gains can be justified by economic fundamentals. For example, the lack of supply in the real estate market. With others, such as cryptocurrencies, the price gains are speculative. Looking at the stock market, I'd say it's frothy but manageable.

It sounds like the inflationary trend we're seeing will be good for those with financial assets, but bad for people on the lower end of the economic spectrum struggling with rising food and gasoline prices. What does this mean for an inclusive economic recovery?

The effects of inflation are always felt unevenly. That's why central banks have made it a policy to control it – it impacts the purchasing power of the people who can least afford it. There are calls to increase the minimum wage in both Canada and the U.S., and if we see a sharp spike in the price of things like food, we could very well see those wage gains happen.

What does the current economic cycle mean for banks?

I see especially bright prospects in commercial banking. Whenever there is any kind of economic dislocation, it increases the demand for advisory services and creates new opportunities in things like mergers and acquisitions. Another thing that is working in our favour is a steeper yield curve. Long term interest rates are rising faster than short term rates, which increases the spread between the rate we charge borrowers and the rate we pay depositors. The bottom line is that North America is growing, and broadly speaking, growth is good for banks.

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