• Recent US and Canadian economic data suggest once again that we have been underestimating the momentum in these economies. 
  • The Russian aggression is clouding the outlook, however. For commodity importers this is a stagflationary shock. For exporters like Canada, the rise in commodity prices provides a powerful offset to the uncertainty and trade impacts of the conflict.
  • The conflict is the most recent among a now long list of serial upside shocks to inflation.
  • Though this is clearly a supply shock, inflation starting points in Canada and the US provide limited flexibility for central banks to look through this most recent development. Modest upward revisions to rate forecasts are necessary to ensure that second round impacts of the conflict don’t add further fuel to rising inflation expectations.
  • In Canada, we now expect the policy rate to rise to 2.5% by the end of this year with a terminal rate of 3% in 2023. In the US, we forecast the Fed will raise its target rate to 2.25% by the end of the year and raise rates by another 25bps in early 2023.

Russian aggression in Ukraine is complicating the task of central bankers. The uncertainty emanating from developments there, how these developments propagate around the world, and their effect on financial markets and commodities is likely to have vastly differing impacts on economies. Those that are closer to the conflict and more reliant on commodity imports are going to be quite negatively impacted. This is the case for much of Europe. For others, such as Canada, that produce many of the commodities being affected by the conflict, the rising value of exports is a powerful offset to the uncertainty and reduced growth prospects in Europe. For all countries, there is no question that developments in Russia and Ukraine are inflationary.

In Canada and the US, recent economic indicators point to a stronger expansion expected in late 2021 and early 2022. This momentum is leading to an upward revision to growth in Canada for instance, despite the situation in Ukraine. This alone warrants an upward revision to our rate calls. The impact of much higher commodity prices across a broad range of raw materials coming from the Russian aggression should provide a powerful economic boost to Canada. We are, however, offsetting much of that positive impact to take into account heightened uncertainty. This results in forecasted growth in real GDP of 4.3% in 2022 and 3.2% in 2023. That forecast remains below what the BoC had forecast in its January Monetary Policy Report, which Governor Macklem has indicated would likely be revised upwards in its April Monetary Policy Report. So, we are by no means on the optimistic side of forecasters. If we, or the BoC, are correct, the growth to come over the next couple of years will be the strongest 2-year growth period since 1999 if we exclude 2021 given that it was boosted by a COVID rebound.

This exceptionally strong growth environment will add to inflationary pressures, but so will the impact of Russian aggression on commodity prices and associated supply chain disruptions. Assumptions about the conflict and the duration of its effect on commodity prices are of critical importance to the inflation outlook. For the moment, we assume that sanctions peak over the next 12 months and that commodities remain elevated relative to pre-conflict levels for that time. We have no crystal ball, and the disruption could well last much longer, or less long than that. We will adjust our forecasts in time once we have more clarity on the realism of that assumption. An early point of reference is Russia’s statement that it would limit or cease exports of raw materials until at least December 31.

The combined impact of greater economic strength in Canada along with the implications of our commodity price assumptions is leading us to significantly raise our inflation forecast. We see year-over-year inflation rising from the 5.1% seen in January to 6.2% in 2022-Q3. For the year, we see total inflation averaging 5.9% in 2022, falling to 3.1% in 2023. Both are clearly quite some distance from the BoC’s 2% target.

There is a debate on how central banks should best respond to current inflationary dynamics. In principle, central bankers should look through supply shocks. The impact of the conflict is clearly a supply shock, so by that logic the Bank of Canada and other central banks should largely look through these developments. That would be correct so long as there was no evidence of these shocks leading to second round impacts or rising inflation expectations. With inflation well outside the BoC’s 1 to 3 per cent inflation control range, and businesses expecting to increase prices by 4.5% over the next twelve months (according to the CFIB’s February Business Barometer, which does not capture the impacts of the Russian aggression), we believe Governor Macklem does not have much flexibility in dealing with additional shocks to inflation. We think the BoC is falling farther and farther behind the curve. As a result, we now predict that it will raise its policy rate by an additional 2 percentage points this year, ending the year at 2.5%. Another 50bps of tightening is forecast for next year, leaving the terminal rate at 3%. This is 50bps higher than our last forecast.

There is no doubt that this is an aggressive call in relation to the views held by others, but we believe the inflation outlook requires such a response. Given the serial upside surprises to inflation in recent months, the balance of risks to inflation and its consequences has shifted up and we consider that a more aggressive policy response would better guard against downside risks associated with higher inflation than a more gradual approach.

A very similar dynamic is in play in the United States, as inflation continues its upward path. As elsewhere in the world, we expect a shift from expenditure on goods to services will relieve some of the upward pressure on inflation, but service price inflation is also trending up now. Much like in Canada, the Fed must weigh current and future inflationary dynamics in the context of rising concern about the consequences of inflation and a potential reduction in the Fed’s credibility. For these reasons, we have added 25bps of tightening to our US Fed Funds target rate forecast. We now forecast a 2022 year-end rate of 2.25, followed by an additional 25bps move in early 2023.

Table 1: International: Real GDP, Consumer Prices, Commodities 2019 to 2023
Table 2: North America: Real GDP 2019 to 2023 and Quarterly Forecasts
Table 3: Central Bank Rates, Currencies, Interest Rates 2020 to 2023
Table 4: The Provinces 2019 to 2023