FREE

North America Macroeconomic Update: The Challenge Of Cooling Excess Demand

DBRS Morningstar released its semiannual North America Macroeconomic Update. The U.S. and Canada continued to grow at a solid pace in the first quarter of 2022. Both economies now appear to be operating above capacity, with extraordinarily tight labor markets. However, downside risks to the growth outlook have intensified since our December 2021 Update. High inflation is eroding consumers’ purchasing power and prompting more aggressive monetary policy tightening. The latter has led to a repricing in the bond and equity markets. Demand in rate-sensitive sectors, such as housing, is already starting to moderate. While year-over-year inflation may peak soon, strong demand will keep upward pressure on prices.

Key highlights:

-- Recession risk has materially increased over the last six months. However, we think a soft landing is still the most likely scenario due to tight labor markets, strong consumer spending, and a relatively positive outlook for business investment, particularly in Canada where high commodity prices are boosting profitability.

-- The rise in headline inflation has been partly driven by exogenous factors, such as rising global commodity prices, production bottlenecks in the auto sector, and economic reopening effects. However, the primary drivers of inflation are shifting from pandemic and geopolitical shocks to excessive demand. These inflation dynamics highlight that even as year-over-year inflation may start to decline within the next several months, the path back to 2 percent will likely be gradual.

-- With the Federal Reserve and the Bank of Canada signaling a more aggressive response to inflation, monetary policy settings are set to shift to a moderately restrictive stance by year-end. It is unclear whether such a policy stance will be sufficient to quell excess demand. The key risk to the growth outlook is if the Federal Reserve and Bank of Canada act even more forcefully than currently expected in order to tame inflationary pressures.

“Slower global growth, tighter macroeconomic policies, and less favorable financial conditions will likely slow growth over the next 4-6 quarters,” said Michael Heydt, Senior Vice President, Global Sovereign Ratings. “The extent of the slowdown will largely depend on whether nominal wage growth persists and consumers continue to draw down savings. Consecutive quarters of negative growth cannot be ruled out. However, absent further shocks, strong underlying demand in the U.S. and Canada suggest that if there is a recession in the next 12 months, it would likely be shallow and short-lived.”