Economic Outlook for 2023: Soft Landing or Hard Impact?

Economic events during 2022 were dominated by the rise of global inflation, surging to the fastest pace in decades. Economists had thought this spectre was long dead and buried, after years of seemingly effective oversight by central banks to keep inflation subdued.

But following the disruptions and chaos of COVID, the inflation zombie suddenly rose from the grave. A combination of supply shocks from lockdowns, transportation disruptions, huge shifts in consumer demand (with travel and eating out replaced by purchases of home electronics and building supplies), and a major energy price shock, global prices took off. 

The second act of this drama will play out in 2023. But the main actor won’t be inflation itself, already abating. Rather, the year will be dominated by the side-effects of policies enacted to curtail inflation.

Despite the unusual features of post-COVID inflation, central bankers responded by pulling out a forty-year-old hymnbook. Developed after the wage-price spirals of the 1970s, that old-time gospel preaches that inflation is caused by overheated labour markets, greedy unions, and accelerating wages. The remedy is high interest rates to cool off spending, recreate a desirable cushion of unemployment, and restore enough fear and insecurity among workers to keep wages firmly in check.

Although Canada’s inflation is significantly lower than the U.S. and most other OECD countries, the Bank of Canada took up this crusade with gusto. It lifted its policy rate from 0.25% to 4.25% – the fastest monetary tightening in Canadian history, and second only to the U.S. among major industrial countries. Interest rates on mortgages, credit cards, and car loans soared much higher.

Canadian households are now suffering an unprecedented shock from this ice bath of monetary restraint. Annualized interest payments by consumers soared $27 billion from early 2022 to the autumn quarter (most recent data available). That’s about 1 full percentage point of GDP, enough to cause consumer spending (which accounts for over half of the economy) to shrink.

But the worst is yet to come, since it takes 12 to 18 months for higher rates to trickle through mortgage refinancing and other channels. Typical families will need to find $1000 per month or more for extra interest when their mortgages turn over. The domestic economy fell into recession in the autumn; only expanding exports kept GDP growth above zero. The slowdown will deepen in 2023, as declines in consumption, housing construction, and business investment drag down overall incomes, GDP, and employment.

It seems perverse, but this is exactly what the central bankers are trying to achieve with their effort to chill spending. In this worldview, any government efforts, however small, to ease the pain of Canadians (like the federal government’s modest enhancements to low-income tax credits) only perpetuate the inflation the Bank is trying to squash. Governor Tiff Macklem put it bluntly in a Toronto speech in November: he wants unemployment to increase, because he thinks labour markets are “unsustainably” tight and wages (which have lagged behind inflation for 21 straight months) are growing too fast. Workers must suffer job loss and still more real wage reductions to fix inflation that was clearly caused by others.

The Bank and a few other optimistic forecasters are hoping for a ‘soft landing’ next year: a stall in growth for a few months, perhaps enough to technically qualify as a recession (defined as two consecutive quarters of contracting GDP), but only a mild one. Others are less sanguine about the depth and length of the coming slowdown. History suggests interest rate hikes of this magnitude lead to painful recessions, with much higher unemployment and many other economic, social, and fiscal consequences. After the hardship and uncertainty of the last three years, a harsh recession will be a bitter blow indeed – all the more so knowing it was avoidable.

Ironically, inflation is already coming down, as the global disruptions that pushed prices skyward reverse themselves. Shipping costs, energy prices, and many minerals and agricultural prices have fallen steeply in recent months. Canada’s year-over-year inflation rate eased slightly to 6.8% in November – and much more moderation is in store, regardless of interest rates. Gasoline prices are closing out 2022 lower than they started the year; that alone will trim inflation by a full percentage point or more.

Some will claim this slowing of inflation vindicates the determination of central bankers to cool off the macroeconomy – even though prices were moderating anyway, and it’s too soon (even in the Bank’s own models) for interest rates to get the credit. Meanwhile, the economy risks serious recession from an interest shock that was neither necessary, nor effective in reducing inflation. Hundreds of thousands of Canadians could lose their jobs, and many their homes.

Why? They’re being sacrificed to visibly reassert a doctrine that keeps unemployment deliberately high – not just to control inflation, but more importantly to control workers.