The choice between a recession and inflation…

Benjamin Tal: That’s a very, very good question, a very tough one. I suggest that in order to do so, you have to change the inflation target officially, yeah? And it’s not going to happen. It’s not going to happen because they just renewed their mandate. If you ask me, we have to at least start toying with the idea of maybe some structural changes in the economy.

Bipan Rai: Hey everyone and welcome to yet another edition of the FX Factor podcast. For today, we have one of Canada’s most esteemed economists, Benjamin Tal, to discuss a broad array of topics related to the global macro environment. And of course, these are very, very interesting times. We’ve got a couple of very important central bank meetings that are coming up here in North America, as well as some important data points that could factor into those decisions. So we thought it’d be prudent to invite Ben back on to the podcast. And of course, he’s been one of our popular guests from the past. Firstly, welcome, Ben. Good to have you on.

Benjamin Tal: Thank you. It’s a pleasure.

Bipan Rai: Yeah, absolutely. We’ve got a lot to talk about so, you know, we’re routinely discussing our central bank calls here at CIBC and of course, we’re on similar email chains when that does happen. And we’ve been doing so more and more regularly of late, given how hot the inflation data has been coming in. And we know that the Fed in June just hiked by 75 basis points and we’re expecting them to deliver on another 75 basis point hike in July. Can you walk us through why?

Benjamin Tal: Yes, because you have no choice. Listen, we are dealing with a significant amount of uncertainty in the market. Just the other day, quite frankly, somebody asked me, what do you think Putin will do next? And I said, you know what? Next time I have coffee with him, I will ask. Like nobody knows, including, you know, the Bank of Canada and the Fed. So we are all guessing. At this point, you look at inflation, it is much, much hotter, much higher than expected. The Bank of Canada has no choice but to move by 75 basis points to follow the lead of the Fed. I think that they have no choice because at the end of the day, as you know, this is not about inflation, this is not about inflation staying at 7, 8% forever. This is about the cost of bringing inflation down to 2%. The fight is over inflation expectations. If they start rising like in the seventies, all bets are off, and that’s exactly what they’re trying to prevent. So they’re going to be very, very militant and they will start raising in a very significant way. And again, the story is just about expectations, making sure that the expectations remain low. And therefore, the message to the market is we mean business. We move strongly and we make sure that inflation expectations go down.

Bipan Rai: Yeah and very good point. I do see a lot more of that focus in the market about where the peak is in terms of year over year inflation. But as you mention, it’s really all about the path back to 2%. What are you expecting for that path going forward in the US if the Fed does as we expect and as per our forecast, I mean, do you see a gradual decline back to 2% or is it going to be very choppy still going forward?

Benjamin Tal: I think it will take a while. And of course, you have to make an assumption here about COVID and where COVID will be a year from now. And if we assume for a second that 2022, at the end of the day is a transition year from a pandemic to an endemic, then it’s reasonable to suggest that the supply chain issues will diminish over time. The question is, and that’s key. The question is whether or not it’s soon enough to prevent the Bank of Canada and the Fed from overshooting. That’s the key issue. I have no doubt in my mind that a year from now you and I will not be discussing supply chain the way we are discussing it now. And that’s, in my opinion, still 60, 65% of inflation. So it’s not just the math. It’s clearly supply. And supply is a function of the virus. If you tell me that COVID is going to diminish, it will not disappear, but it will be a transition year from a pandemic to an endemic, then I’m telling you that supply chain issues will diminish as well. So that’s extremely, extremely important because as we know, the Fed and the Bank of Canada cannot control the supply issue and the inflation that comes with it. So that’s where they are. Now we have to realize one thing. We have to realize that if you give the Bank of Canada or the Fed two options, one is inflation expectations rising, the other is a recession, they will take recession any day. That’s the key. So we see inflation stabilizing, probably reaching peak in next month or two. The best year is definitely helping us. Energy is starting to stabilize, commodity prices are starting to stabilize and the impact of commodity prices on inflation is coming with a lag. So therefore we suggest that peak inflation, not peak panic, but peak inflation might be over the next two or few months, but it will go slowly, slowly, slowly, and you have to be really lucky to get 2% next year.

Bipan Rai: Right. And when we look at this composition of CPI, not just from a supply demand perspective, a lot more of it is being driven by services now instead of goods. What does that mean for the Fed going forward? Can we expect service related price pressures to be more resilient, for lack of a better term, against tighter monetary policy? Is this a real challenge for central banks in the period ahead, in your opinion?

Benjamin Tal: Well, it’s a major challenge, but we have to remember that before COVID, the service inflation was 3%, goods inflation was about 1%. So the average was about two. Now, clearly, goods inflation is still very elevated, although I believe we’ll start going down with supply chain issues diminishing. The service sector is definitely inflationary, but it’s less inflationary than goods. Why? They don’t have the same supply chain issues that goods have. Basically, if you start overcharging on your restaurant, I will open a new one to compete with you. So the supply curve of services is more elastic and that’s actually disinflationary. So that’s a good thing. Although in the short term, as we open up and there is not enough capacity, clearly prices will rise and that’s a challenge that they’re facing. And that’s why that’s something that they can control vis a vis higher interest rates. And that’s why they will be so militant.

Bipan Rai: Right. And speaking of the Fed being militant, I mean, we’re expecting them and they’ve sort of conceded this point as well, that they’re going to take policy settings into restrictive territory. Can you explain to our listeners what they mean by restrictive territory?

Benjamin Tal: Well, there is an issue of neutral rate. Now, nobody knows what the neutral rate is, like in the car. when you put in neutral, you basically don’t move. You’re not accelerating, you’re not decelerating. We estimate this number to be between 2.5 and 3%. What the Fed is telling you, we might take it beyond that. If you go over neutral, which means basically we are going to make sure that the economy is slowing down because it needs to slow down to fight inflation. So they’re going to tighten conditions. That’s what they are telling us and that’s what the market is pricing in. The market is pricing now well above 3.5% Fed funds rate. Our call is that you get to three and you basically stay there. But that’s a big, big risk that we will overshoot. And let me remind you that in my opinion, at least, every economic recession was helped, if not caused, by a monetary policy error in which central bankers raised interest rates way too much and were overshooting. The problem is, you never know that you overshoot in real time.

Bipan Rai: Right. And to your point, that’s a proximate risk for this cycle at the end of it. And I mean, I’ll circle back on the odds of recession going forward, but I just wanted to really tie in what we’re expecting with respect to the Fed and what they’re thinking as well as what the market is pricing in. Now, as you mentioned, we’ve got the mid-point of the Fed funds rate just slightly north of 3% by the end of this year, whereas the market’s closer to 350 basis points or 3.5%. And the Fed itself has said that they can get as high as, say, 3.8, 3.9% by the end of this year. What are we seeing differently than what the market is seeing? And maybe what the Fed is seeing as well, to really have our forecasts a little bit lower than what they have?

Benjamin Tal: Yes, that’s a tricky one, because, again, nobody knows. And the issue why they can overshoot is the fact that inflation is a lagging indicator. Inflation is telling you what happened in the past. The inflation peaked, peaked six months on average after the beginning of each recession over the past four or five cycles. So clearly, we have an issue in which show me the central banker that will stop pricing interest rates when inflation is still accelerating, despite the fact that the economy is slowing. So that’s the risk that we are facing to our forecast and we admit that risk. At the same time, we look at other forces, one of them is inflation itself. That will start impacting the psyche of the consumer, the ability of the consumer to consume and that will slow down the economy. Fiscal policy is actually a negative, and that’s something that will be, again, a factor that might limit the need to raise interest rates more than 3% because fiscal policy will help here. And then you have other forces. Supply chain. The hope and the prayer is that we will start seeing some improvement. We talk to a lot of CEOs in the field. They are saying that things are starting to stabilize. If we see supply chain starting to improve, that will be a very significant signal to the Fed that maybe enough is enough. And then you have the housing market. Clearly in Canada but also in the U.S., the housing market will slow down under the weight of higher interest rates and that will be a major factor that will lower GDP growth and maybe even inflation. So that’s our call. We believe that 3% will be sufficient. You go beyond that, you increase the probability of a recession significant.

Bipan Rai: Right. And of course, you know, Chair Powell for the Fed has been saying for the last little while at least, it’s very clear that 75 basis point hikes shouldn’t be considered the norm. And really what I want to get a sense from you is that what should we look at in order to gauge whether or not they’re going to switch from, say, 75 basis point to 50 basis points after this July meeting or even ahead of this July meeting, if there is any sort of evidence. I mean, are there particular indicators that you’re eyeing? Obviously, inflation would be one of them. But anything else beyond that we should be looking at?

Benjamin Tal: Yeah. First of all, the consumer, to what extent the consumer is starting to react to higher inflation and clearly higher interest rates, that will be number one. We need to see some softening in the labour market. That’s number two. And then we’ll have to see the housing market continuing to slow down. And that’s a major factor that will impact the psyche of the Fed. And in between, we have to look at the supply chain and see if we are starting to get a sense that it’s starting to ease. And the Fed has many ways to measure it directly and indirectly.

Bipan Rai: Right. Now let me take things the other way and sort of look at risks from the other end of the spectrum. Two parts here. Two parts of this question. Firstly, do you agree that the Fed is behind the curve when it comes to inflation in the US?

Benjamin Tal: Yes, absolutely.

Bipan Rai: OK. Secondly, what would it take for them to move in 100 beep increments instead of just 75?

Benjamin Tal: You see, if it was so easy, then they will go with 100. But it’s not easy. Why? Because then they submit a signal to the market that they are panicking. The Fed has to be seen being in control at any point in time. So if you go 100, you basically tell the market, you know what, I screwed up. I really, I’m late, I need to fix it. I’m panicking. I don’t know what will happen. That’s the worst thing that you can send as a message to the market. 75 is some sort of compromise between 50 and 100. So to me although maybe they should move by one hundred, in my opinion, they will not just because of the signal that that will submit to the market.

Bipan Rai: Yeah, I would agree with that assessment as well. Going back to this, what you said earlier with respect to the consumer and really eyeing that data that points to possible demand destruction there, I mean, some of the forward looking data that we received from the US in terms of early PMI as well as the eurozone is pointing towards a slowdown in sort of forward looking activity potentially. We have yet to see that reflected in real data. In particular, last week’s PMIs did suggest that there was a growth in new orders sent to US manufacturers had declined. When can we expect this to show up in the real data itself? In other words, like when can we expect that tighter monetary policy conditions are starting to take a bite out of the US consumer?

Benjamin Tal: I think we are there already. I think that we are starting to see it and will see it over the next few months in a very significant way. People say that the impact of higher interest rates work with a lag. It’s true, but at the same time, this lag is much shorter than it used to be. Remember, you move from basically zero interest rates to something much higher than that in a very short period of time. You shock the system, so you see the impact immediately. Clearly in the housing, the consumer and many other forces. The issue is really, at the end of the day, is not demand, it’s supply. We need to deal with supply chain and that’s something that nobody can predict it. And the Bank of Canada and the Fed cannot do anything about. What’s surprising at this point so far is that we are expected to see spending on goods to slow down, and it’s not slowing as quickly as I would like to, quite frankly. You know, after consuming like crazy in 2021, we basically squeezed four years of consumption into one year of goods in terms of growth in 2021, because it was easy, you press the button and you get your exercise bike and people say, yes, never underestimate the American consumer. And I say, yes, but give me a break. How much stuff do you need? But quite frankly, if you look, they are still accumulating stuff in addition to services. And that’s the consumer, the American consumer, more, by the way, than what we see in Canada and Europe, which is very interesting.

Bipan Rai: Yeah. So a good point you just brought up there in terms of the actual rate hike and the transmission mechanism to real economic activity maybe being a little bit more quicker. But I mean, central bankers have been keen to push this sort of messaging we’ve heard over the past several years in terms of taking several quarters before tighter policy makes its way to the real economy. I mean, would you agree that that window has shrunk and why has it shrunk, in your opinion?

Benjamin Tal: Well, big time. Big time because the sensitivity to higher interest rates went up, especially during COVID. Clearly, we know in Canada and we’ll talk about Canada later, I believe. But even in Canada, even in the U.S. with the housing market, you look at the impact and it’s immediate. So I think that the window is much narrower now than before when it comes to the effectiveness of monetary policy. And that’s a good thing. That’s something that will enhance the ability of the Fed and the Bank of Canada to deal with the situation. The economy is much more dynamic, the labour market is much more dynamic. Therefore, the lags that we were talking about in the past are irrelevant in today’s environment.

Bipan Rai: Okay, so let’s switch things up and talk a bit about Canada. I mean, we’re expecting 75 basis point hike from the Bank of Canada at the July meeting. Can you give us a sense of why we’re expecting that and where we see the bank’s path on balance for the rest of this year?

Benjamin Tal: Well, first of all, the Fed moved by 75 basis points. So that’s opening the gate for the Bank of Canada to do the same. Can you imagine what will happen to the dollar if they don’t? So I don’t think that that’s something that they would like to see. So quite frankly, they are not going to disappoint the market. We’re going to get 75, not 100 basis points for the same reasons why the Fed is not doing it. But clearly you look at inflation in Canada, it deserves 75 basis points and the Bank of Canada will do that. There is no question about it. The next move, we believe, will be 50, 25 and they will call it a day. Now, our call again is lower than what the market is projecting in terms of pricing, the terminal rate as far as the Bank of Canada is concerned. And that’s again for many reasons. In addition to what I mentioned regarding the Fed and the housing market is also the increased sensitivity of the economy to higher interest rates. We know and we discussed it in the past that the Bank of Canada has more power to impact the consumer relative to the Fed because we carry much more debt and our mortgages are usually for five years and less, in the US, 30. So what I’m telling you here is that the tiny Bank of Canada is more powerful than the mighty Fed when it comes to impacting the consumer. And therefore we believe, by the way, that the terminal rate in the US will be higher than in Canada. Something that is not priced in by the market.

Bipan Rai: Yeah. Would agree with that assessment completely. And we all understand that the housing market is an integral part of the Canadian economy and we’ve seen some degree of slowdown there. Do you think there’s more room to fall when it comes to house prices in Canada, in particular for the greater Toronto and Vancouver areas?

Benjamin Tal: Absolutely. I think this is just the beginning and that’s a good thing. I think that the prices will go down, led by the low rise segment of the market, very similar to what we have seen in the 2017. But more significant because now we see a significant increase in interest rates more than we saw in 2017. We reached a resistance level when it comes to prices, especially in the low rise segment of the market. So clearly we will see a situation in which prices will go down with sales and that’s a very good thing. What will limit the decline will be lack of inventories. The supply issue is definitely a factor here that will limit the decline. In addition, we have to remember that although the reduction in demand now and the slowdown will ease the pressure when it comes to supply, I think that we are planting the seeds for higher prices down the road. Why? Because I have conversations with many developers, big ones, major ones, and all of them, almost with no exceptions, are cancelling or delaying projects. Why? Because construction costs are so high, interest rates are rising. They cannot make money, especially rental units, which means that they are not building now. So when we wake up from this recession or semi recession and we wake up and we improve and we recover, the demand will be there, the supply will not be there because we are not building here now. That’s extremely important to understand. So what we are seeing now is not a major correction. It’s an adjustment after seeing prices rising by 50%, but in two years. But this is not the beginning of a major correction in the market because the fundamentals of that market are so strong and the supply issue will become worse, not better over time.

Bipan Rai: So said differently, you’re of the view that this is a temporary reprieve for house prices, at least in the here and now. And we’re not really, at least from a fundamental perspective, anywhere close to where we were, say, in the early nineties. And of course, you know, I get reminded all the time by my parents and my aunts and uncles about how tough that environment was. Do you think we’re headed in that same direction or do you think this is a bit different than then?

Benjamin Tal: No, this is a lot different than the 91 situation in terms of speculations, in terms of bad debt, in terms of subprime. This is not even close to what happened in 1991 and clearly not 2008 in the U.S.. This is not the discussion. I think if you look at 91 and 2008 in Canada, 2008 was a relatively mild version. We were second hand smokers to the 2008 financial crisis in the US. It was not our recession. Therefore, the impact on the housing market was short lived. We will get something in terms of magnitude in between 91 and 2008. It will not be 91 because the fundamentals of the market are much, much stronger. And remember, we have stress tests. We have many other things that will prevent the vulnerability of borrowers and you will not see a significant increase in defaults. Although clearly the code that took mortgages in 2020, 2021 will be the one that is most exposed down the road four years from now, five years from now. But overall, the fundamentals of the market are very strong. We need a significant adjustment slowdown in the market, and that’s exactly what we are going to get. Every economy, every system needs a reset and we are getting ours now.

Bipan Rai: So recently you and Andrew have penned some really good stuff on the Canadian labour market and how the pandemic basically accelerated some structural changes within that are leading to high vacancy levels that the Bank of Canada has recently made reference to. What are those changes that you referred to in your note and what are the risks going forward?

Benjamin Tal: Yes, that’s a fascinating story because, you know, you look at the share of low paying jobs in the economy. We follow it on a regular basis. So during the recession, during COVID, the share of low paying jobs went down dramatically, which makes sense because most of the jobs that were lost were service sector jobs. We all know the story. They lost their jobs. That was the story that there was the asymmetrical nature of the crisis. Okay, makes sense. Now, the unemployment rate is back to normal. The employment rate is back to normal. The labour market is back to normal. You look at the share of low paying jobs, still down. So the question is, where are they? So people say, oh, they are all watching Netflix at home because they’re young people. They don’t want to go back to work. That is not true because if you look at the participation rate, it’s back to where it was for this age group. So it’s not that they’re slacking off. Something else is happening here. And I suggest and that’s extremely important to understand that COVID accelerated a structural change of historic proportions in the labour market, namely the labour market opened up. In the past, if you were a university educated individual and you were trying to find a job in Toronto, you couldn’t find anything, you were serving coffee at Starbucks. We know the mismatch in the labour market. People without jobs, jobs without people. I suggest that now with the ability to Zoom to work remotely, you are able to find jobs that are consistent with your skillset. So they are doing that, but nobody left to serve coffee. So listen to this, 100%, not 99, 100% of all new jobs that were created during COVID were among university educated individuals. This is huge, which means that the shortage of low paying jobs, the shortage of individuals working on those jobs is real and structural. And maybe that’s the way the market is telling us that they have to pay more and improve working conditions for those individuals. Their wages are rising much faster, and the lower your wages, the higher your wage inflation is. That’s the way it should be.

Bipan Rai: Yeah, absolutely. That is an absolutely fascinating story. And certainly we’ll have to reframe the way we think about the labour market here in Canada and certainly wages as well. And again with respect to wages in both the US and Canada. I mean, outside of this, can you explain other reasons why Canada has been lagging the US in that department?

Benjamin Tal: That’s very interesting because I will say that the Canadian labour market is more supplied. Although we are still missing a lot of workers, the vacancy rate is much, much higher than it was. We need 1 million jobs. We know the story. It’s much less than in the U.S. for two reasons. One is immigration. Immigration is a big, big story. We have to go back to October 2020. The Canadian government is announcing we would like to see no less than 400,000 new immigrants in 2021. And people said, are you crazy? How can you get 400,000 new immigrants? There’s COVID. Nobody’s moving. We got 401,000 new immigrants. Why? Because they were already here. 70% of those new immigrants were already here. They were students. They were not permanent residents. They were foreign students. And the government said, while you wait, just why don’t you apply to be a permanent resident? That’s exactly what happened. This is six times more per capita than what the U.S. got. So we have many more new immigrants, especially in high paying jobs, which is extremely important to understand because they were, you know, the young, they speak the language, they have a job experience and they are more educated. So most of the increase in jobs came from highly educated immigrants in high paying jobs. Again, nobody left to serve coffee. That’s very interesting, but that’s number one. Number two is foreign students themselves are working in the labour market much more than you see in the USA. So the Canadian labour market still needs people, but it’s more supplied than the U.S. and therefore wages in the U.S. are rising faster.

Bipan Rai: Right. So now, given everything we’ve heard and that the audience has heard, I should say, and everything you said, I’m going to hold your feet to the fire a little bit. Give me odds of a recession here in North America for both the US and Canada. And how will they compare? Will it be more severe in Canada relative to the United States?

Benjamin Tal: At this point, I will link the probability of a recession to the probability of overshooting by the Bank of Canada and the Fed. And that probability, in my opinion, is approaching 40%. So it’s a very significant probability. It’s almost 50/50. And we have to realize that that’s the situation. I’m not going to sugarcoat anything here. This is the way it is. We are in a situation that we haven’t seen in generations. We were addicted to low interest rates. Interest rates are rising and will continue to rise very, very rapidly. That will shock the system and that can take the system to a recession. We know that and therefore 40% probability is a reasonable probability. However, important to note on both sides of the border, I think that the recession will be milder than other recessions, especially in the U.S. And that’s because of the fact that we have the consumer sitting on still a significant amount of cash. That will make the situation better. And I think that the fundamentals of the housing market will put a bottom to the decline there.

Bipan Rai: Very good point. With respect to the consumer, potentially ensuring that this is a milder recession than we’d otherwise believe. Another question for you, and this is sort of a bonus question before we wrap up this podcast, do you think that the floor for inflation is going to be higher going forward? Do you think there’s structurally that we’re entering a new regime relative to where we were heading into this pandemic?

Benjamin Tal: That’s a very, very good question, a very tough one. I suggest that in order to do so, you have to change the inflation target officially, yeah? And it’s not going to happen. It’s not going to happen because they just renewed their mandate. If you ask me, we have to at least start toying with the idea of maybe some structural changes in the economy and not just the labour market, but also deglobalization. If globalization was disinflationary, guess what deglobalization is? So there are some major forces in the supply side of the economy that can impact what should be the target. I’m not sure. The discussion at least should start. However, that’s academic because it’s not going to happen anytime soon since the mandate was renewed for the next four years. Therefore, what it means? It means that the economy will have to go slower and interest rates will have to be higher in order to maintain the 2% target. That’s the key issue now.

Bipan Rai: Okay. Thank you so very much for joining us today. Ben, always a pleasure to have you on. And we’d love to have you back.

Benjamin Tal: My pleasure. Good luck.

Bipan Rai: Excellent. Thank you, everyone, for joining us. Until next time.

Disclaimer: The information and data contained herein has been obtained or derived from sources believed to be reliable, without independent verification by CIBC Capital Markets and, to the extent that such information and data is based on sources outside CIBC Capital Markets, we do not represent or warrant that any such information or data is accurate, adequate or complete. Notwithstanding anything to the contrary herein, CIBC World Markets Inc. (and/or any affiliate thereof) shall not assume any responsibility or liability of any nature in connection with any of the contents of this communication. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice. CIBC Capital Markets is a trademark brand name under which different legal entities provide different services under this umbrella brand. Products and/or services offered through CIBC Capital Markets include products and/or services offered by the Canadian Imperial Bank of Commerce and various of its subsidiaries. For more information about these legal entities, and about the products and services offered by CIBC Capital Markets, please visit www.cibccm.com. Speakers on this podcasts are not Research Analysts and this communication is not the product of any CIBC World Markets Inc. Research Department nor should it be construed as a Research Report. Speakers on this podcast do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned. The commentary and opinions expressed herein are solely those of the individual(s) ,except where the speaker expressly states them to be the opinions of CIBC World Markets Inc. Speakers may provide short-term trading views or ideas on issuers, securities, commodities, currencies or other financial instruments but investors should not expect continuing analysis, views or discussion relating to these instruments discussed herein. Any information provided herein is not intended to represent an adequate basis for investors to make an informed investment decision and is subject to change without notice. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice.