From the Desk

As expected, the U.S. Federal Reserve left rates unchanged. Markets were already resigned to fewer rate cuts this year, with an increasing probability there could be none. The U.S. economy continues to thrive even as inflation moves sideways. Strong labor market demand has been met with an unexpected surge in labor supply, which has driven today’s resilience.

In his press conference, Fed Chairman Jerome Powell helped soothe markets, noting the economy was “not reaccelerating” while monetary policy remains restrictive. This in turn led him to bookend his monetary policy scenarios. As Powell implied there was little chatter among Federal Open Market Committee members on the need for hikes. And when asked about the risk of stagflation – the toxic blend of anemic growth and high inflation – he whimsically responded he saw neither the “stag” nor the “flation.” But it is worth adding that the chairman’s quip came after a thoughtful recap on what real stagflation looked like in past episodes, which bear little semblance to current dynamics.

The main surprise in the update was the Fed’s decision to slow the runoff of its balance sheet. On the face of it, this should keep rates marginally lower and allow more time for markets to adjust to less Fed liquidity in the system, in turn limiting the risk of market stress.

Sources: Financial Times, Bloomberg, 2024.

While inflation remains undoubtedly hot in the U.S. following elevated Personal Consumption Expenditures (PCE) deflator (the Fed's preferred inflation gauge) and Institute of Supply Management (ISM) Prices Paid readings, growth signals have become decidedly more mixed. Q1 GDP growth notably slowed to 1.6%, while the ISM Manufacturing Purchasing Managers’ Index sank below the all-important level of 50. However, consumption figures have been extremely robust, consumer and retail companies' earnings have been strong, and wage measures such as average weekly earnings and the employment cost index are elevated.

For more insights, it may be useful to consider the experience of the U.S.’s neighbor. In Canada, record-breaking immigration increased the population by 3.2% in 2023, following a 2.4% increase in 2022, such that GDP per capita since then has declined on a real basis despite growth in the overall economy. While U.S. immigration has not been so dramatic, similar effects could well be at play here given the deceleration of GDP growth to a level that is more in line with presumed population increases. As a result, consumption strength is less meaningful than it may appear, while the strength of wage measures in the U.S. could well be overstating their economic impact. That’s because millions of undocumented workers are paid lower-than-average wages outside of the traditional economy and face more elasticity in employer demand than documented workers.

However, Canada's economy is still not yet in recession although stress on households has been more pronounced in Canada for a number of additional reasons that do not affect the U.S., such as mortgage rate resets and currency depreciation. As a result, we believe the pace of any weakening in the U.S. will be manageable and modest in the absence of additional catalysts, which could come in the form of geopolitical events, the U.S. Presidential election or some sectoral credit event along the lines of the regional banking crisis. In such an environment, we see continued runway for spreads to remain relatively range-bound despite tight levels.

Source: Bloomberg, BMO, Statistics Canada, Evercore ISI, 2024.