‘At some point we’ll risk reaching a tipping point toward recession’

Senior economist says stakes are high as inflation pressures persist

‘At some point we’ll risk reaching a tipping point toward recession’

With inflation in Canada raging at a 40-year high, all eyes are on the country’s central bank as it’s expected to ramp up its aggressive rate-hiking campaign – hopefully without derailing Canada’s economic growth.

But with inflation pressures set to persist well past 2022, the Bank of Canada is walking a delicate tightrope, according to one economist and portfolio manager.

“I think it’s important to realize that if we have a recession, it’s going to be more technical in nature,” says Sebastien McMahon, Chief Strategist and Senior Economist at iA Financial Group. “When the pandemic happened, we saw a lot of fiscal and monetary spending that led to the strength and exuberance in the economy and markets during 2020 and 2021. Now we are seeing the after-effects of inflation and going into an economic slowdown … It won’t be like the ones we saw in 2008 or 2020, which were some of the worst in history.”

Like many other observers, McMahon is expecting the Bank of Canada to announce a 0.75% rate hike in July. Even barring the unexpectedly strong 7.7% inflation print announced last Wednesday, he says both the BoC and the Federal Reserve need to bring monetary policy to the neutral rate as quickly as possible. For Canada’s central bank, the neutral rate is between 2% and 3%.

“Recently, the BoC’s Deputy Governor Phillip Beaudry flagged that they want to go to the high end of neutral. So I think if you’re the bank, it will be key to get there quickly in 75-basis point increments, which means getting to 3% by early September.”

Even if the central bank were to reach its terminal policy rate of 3%, McMahon says, the odds are inflation will still be elevated above recent history, but at a more modest 3% to 4% annual rate as of late 2023 or 2024. Aside from the demand-driven component of inflation, which the Bank of Canada can address through its monetary policy, prices are escalating from factors that are more supply-driven.

He notes that the Russia-Ukraine conflict has exerted an obvious impact on both energy and food prices. Droughts around the world, including North and South America, are also putting pressure on the global food supply, he adds, and gasoline prices are soaring due to COVID impacting the operating capacity of refineries.

“Of course, it would be a good thing if we had a resolution to the Russia-Ukraine conflict. But I think the damage is done,” McMahon says. “It’s already taboo to do business with Russia; Europe, its biggest customer, is actively working on not relying on Russia anymore. And Ukraine is a large grain producer, so even if the war were to end today, the lingering effects would likely last for multiple quarters and even years.”

Already, he sees the beginnings of a slowdown. The frothiest housing markets, notably in Toronto, are going through abrupt price corrections; meanwhile, stocks and bonds on both sides of the U.S.-Canada border are down for the year. That means countless Canadians are seeing their wealth evaporate, and are likely to cut back on their spending as a result. And with inflation eating into purchasing power, every dollar spent will represent even less of an economic push in real terms.

“I hope the Bank of Canada stops at 3%. If they go beyond that, I think at some point we’ll risk reaching a tipping point toward recession,” he says. “I’d say the risk of a recession in the next 12 months is around 35% right now because the labour market is strong, and our exports are doing very well. But we're a small open economy. We're going to be importing lots of weakness, and there's a real risk.”

While he wasn’t partial to the term “stagflation” in 2021, McMahon is inclined to use it in describing today’s environment as inflation eats away at economic growth in Canada. He projects the current stagflationary conditions will likely persist for another year until inflation calms down, possibly during the second half of 2023.

Central bank policymakers have publicly said they were mistaken in their initial understanding of the inflationary conditions, and many observers and analysts accuse the central banks of being behind the curve in pulling out the firehose of monetary policy. But from McMahon’s point of view, the powers-that-be at the Fed and the BoC deserve some consideration.

“I don't think that it would have been doable for central banks to start hiking in 2021 with the uncertainty that we had. The Omicron variant arrived late in 2021, and we went back to lockdowns at the turn of the year. So central banks would probably have done more harm than good if they’d decided to hike then,” he says. “They made a mistake about inflation in hindsight, but I think it was an honest mistake.”