Slowing Economy Should Give Bank of Canada Pause … But It Won’t

New GDP data released last week confirm that higher interest rates and other headwinds have already slowed economic growth in Canada to a crawl. This should give the Bank of Canada pause to reconsider its schedule of aggressive interest rate hikes. That inflation was never attributable to overheated domestic economic conditions. Instead, statistical evidence indicates that current inflation is mostly the result of several unique post-pandemic factors: supply chain disruptions, higher energy prices, and a catch-up of consumer spending from depressed pandemic levels. Moreover, those largely temporary forces are already abating: several key global price indicators have fallen substantially in recent months (including petroleum, food, and shipping costs). By undercutting Canadian spending to reduce inflation that had little to do with domestic demand in the first place, the Bank of Canada is missing the true problem – and risking an avoidable and painful recession.

Statistics Canada’s latest GDP data (released last week) showed headline GDP growth of 3.3% (annualized) in the second quarter of 2022. But that number was boosted partly by strong results recorded in the first quarter. Because the quarterly growth rate is calculated by comparing two quarterly average levels of GDP, economic growth in the latter portion of the previous quarter will lift the level of GDP in the subsequent quarter – even if no further growth actually occurred during that later period. There is thus a degree of inertia embedded in quarterly comparisons that can be especially misleading at economic turning points. This was indeed the case in the second quarter of 2022, when growth slowed substantially – in large part because of interest rate hikes that began in March.

In fact, economic growth during the second quarter already implies a much slower pace of expansion. This is evident from monthly data on GDP by industry; these statistics are not identical to the quarterly national income statistics, but they are a good indicator of within-quarter trends. Growth in the latter weeks of the first quarter was very strong: real GDP by industry rose 0.8% in February and 0.7% in March (see figure). But growth then slowed suddenly in April (to 0.2%), and stayed very weak through the rest of the second quarter (barely above zero in May, and just 0.1% in June). Comparing the June level of GDP by industry to March implies a within-quarter growth rate of 1.6% (annualized), less than half the rate implied by the conventional headline number. Over half of the conventionally reported GDP growth in the second quarter was therefore due to growth that occurred in the previous quarter.

Another worrisome sign in the second-quarter GDP report was an outsized increase in business inventories during the spring. Inventories expanded by $46 billion (annualized), the largest quarterly inventory build in Canadian history. Sudden increase in inventories usually indicate an unexpected deceleration of business sales – forcing businesses to stockpile unsold goods. Without that enormous increase in inventories, Canadian GDP growth in the second quarter would have been negative (see figure).

Other GDP indicators further confirm that interest-sensitive spending is already falling dramatically. Consumer spending on durable goods (such as automobiles and appliances) fell at an annualized rate of 12% in the second quarter. This sudden retrenchment helps explain the large inventory build-up. Residential investment fell even faster: at an annualized rate of 28%. Even government capital and infrastructure spending declined.

Consumer spending on non-durable goods and services remained robust, and that allowed overall household consumption spending to continue expanding. However, there is no evidence to support the contention that consumer spending is “overheated,” and is outstripping the capacity of the economy to produce the goods and services that consumers demand. This is a core assumption behind the Bank of Canada’s strategy to reduce inflation by suppressing domestic spending.

While consumer spending increased rapidly after the re-opening of retail, hospitality, and travel opportunities, it still has not regained its pre-COVID trend trajectory (see figure). Compared to the steady trend established during the decade prior to the COVID pandemic, consumer spending is around $30 billion (or 2%) behind where it would have been without the pandemic. This suggests much of the strength in consumer spending still reflects a “catch-up” of foregone purchases during COVID restrictions. Canadian personal saving rates (6.2% in the second quarter) remain elevated, suggesting there is still more catch-up to come. In this context, the macroeconomic focus should be on stimulating more supply, not trying to restrict demand even further below abnormally reduced levels.

One final indicator that “overheated domestic demand” is not the problem Canada faces, is the emergence of a significant trade surplus in recent months. This largely reflects abnormally high prices for Canadian energy and other resource products. The trade surplus grew to $36 billion (annualized) in the second quarter, equivalent to 1.3% of GDP (see figure). That is the largest trade surplus since the 2008 global financial crisis – another moment in economic history when unsustainably high commodity prices contributed to global economic fragility. In circumstances when overly strong domestic demand outstrips the supply capacity of the domestic economy (as implied by the “overheating” narrative), countries usually experience substantial trade deficits. This is because some of the excess spending power pulls in larger flows of imports. This is not evident in Canada today.

Finally, a critical but under-emphasized dimension of current inflation is its impact on the distribution of income in the economy – and in particular on the division of income between businesses and workers. The acceleration of inflation since mid-2021 has been clearly associated with a significant shift in income from workers toward businesses. And the latest GDP data indicate this regressive redistribution is gaining strength.

In the second quarter alone, with consumer price inflation running at an average pace of almost 8% (far faster than wages), the share of nominal GDP paid to workers in total compensation (including wages, salaries, and benefits) declined by more than one full percentage point. This continues the decline in the labour share of GDP that was established as the economy began reopening after COVID restrictions. Compared to end-2019 (the last full quarter before the pandemic), the labour share has now declined by almost 2 full percentage points (equivalent to a loss of over $50 billion in annual labour compensation). The labour share of GDP has fallen to the lowest point since the global financial crisis of 2008.

The mirror image of the erosion (both relative and absolute) of labour incomes is an unprecedented expansion of corporate profits. Rising corporate profits captured more than one additional percentage point of GDP in the second quarter. This confirms that inflation does not solely or even mostly reflect businesses passing on higher input costs (including labour costs) to customers. To the contrary, business profit margins have swollen markedly. Firms have taken advantage of supply disruptions, the global energy shock, and catch-up demand from consumers to raise prices far more than required to simply preserve their margins. Since end-2019, corporate gross operating surpluses (as measured in GDP accounts) have expanded by 4 percentage points of GDP. After-tax corporate profits (a measure which includes interest payments to banks, not directly counted within GDP) have grown even further: by more than 5 percentage points, to almost 20% of national GDP. That is the highest profit share in Canadian history. Small business income, in contrast, has also declined, but less rapidly than labour compensation.

It is a myth to claim that “inflation hurts all Canadians.” Some well-off Canadians have never done better than they are at present. This is further reason to consider alternative strategies for reducing inflation, rather than invoking higher interest rates to slow domestic activity and weaken labour markets. The erosion of labour’s share of GDP confirms that current inflation cannot be the result of overheated domestic labour markets and rising wages. Real wages have declined (by 3.5% in the last year), and labour’s share of total income has fallen. This is the opposite of the experience in the 1970s, when inflation was accompanied by an increase in labour’s share of GDP. So the old 1970s recipe of countering inflation solely through higher interest rates is not appropriate. This approach blames the victims of current inflation (namely, workers and low-income households) for the problem – and will lead to further declines in real incomes for Canadian workers.

Despite the evidence that the domestic economy is not actually “overheated,” and is not caused by rising wages, it is certain that the Bank of Canada will substantially increase interest rates again this week. This will further undermine domestic spending, and contribute to a further slowdown in job-creation and economic growth. Meanwhile, the U.S. economy (Canada’s largest trading partner) already contracted through the first two quarters of 2022). Depending on global events, the likelihood that Canada will enter recession in the second half of 2022 is growing.

Jim Stanford