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This transcript has been generated using machine learning technology. While this technology was trained with CIBC terminology, it may contain errors.
Avery Shenfeld: Welcome to CIBC&#8217;s Eyes on the Economy podcast. I&#8217;m Avery Shenfeld, Chief Economist at CIBC and today I&#8217;m joined by Helen Lao, a Senior Economist on our economics team, to talk about the outlook for the US and Canadian economies, and the implications for financial markets in the coming couple of years. And we’re doing this at a very auspicious time because there are so many uncertainties circulating now in the wake of the war in the Persian Gulf, and the breakdown of trade relations between Canada and the United States. So, I think we&#8217;ll start with the US economy, Helen, because we just had a FOMC meeting last year and the Fed did hike interest rates for the first time in three years in what was actually a unanimous vote, something that we and the market had expected in light of escalating inflation and higher oil prices. So, Helen, can you walk us through a bit what led to that rate hike and how do you see the current state of the US economy in the wake of those higher interest rates?
Helen Lao: Yeah, so on what led to the hike, first and most important, inflation just hasn&#8217;t been cooperating. We&#8217;re looking at headline PCE inflation, the latest at 3.7%, nearly double of the 2% target. Core PCE is running still more than one full percentage point above 2%. I think one thing that Chair Warsh has mentioned in his press conference is that he&#8217;s been watching the share of PCE components that is above 3% at 6 and 12-month annualized rate. And right now, those shares are still quite a bit above their historical averages. There were some positive signs in the summer months in the CPI data, but that last CPI report we got for August, we actually saw a bit of a pickup in monthly pace of core CPI inflation. So I think that really reaffirms for some people that inflation is just not moving down fast enough. And that&#8217;s exactly how they phrase this hike, as it will support a timelier return to the committee&#8217;s 2% goal. The other important factor, I think, is the recent geopolitical development. There were some escalations in conflicts and supply disruptions in the Middle East recently, which has led to higher oil and gasoline prices since this last meeting in July. So the Fed is worried about higher energy prices broadening into secondary effects, which could kind of de-anchor inflation expectations. So I think they wanted to act before that risk materialized. And really lastly, the labor market also gave them the cover to act. The August jobs report shows that the US labor market is still stable, near full employment, with unemployment rates staying low by historical standard. So raising rates didn&#8217;t really risk tipping a fragile labor market over. So at least the labor side of the mandate is solid, and that frees the Fed up to really lean harder into the inflation fight without worrying they are trading one problem for another. We think the Fed will hike again in October. We don&#8217;t think inflation will have made significant progress until then, and the situation in the Middle East doesn&#8217;t seem to have been improving. So right now, our call is that the Fed will hike twice by the end of the year. As to the state of the US economy currently, I describe it as it&#8217;s still fundamentally solid. We&#8217;re expecting growth to pick up in Q3 and tracking around 2.1% this year. There&#8217;s been two main forces really behind the strength in the US economy, and that is resilient consumption and solid AI investment. That means the US economy is running a bit above its potential, meaning there&#8217;s a bit of access demand in the economy, which could modestly boost inflation. The labor market is still in balanced territory. The unemployment rate is still low, range-bound for quite some time now. Labor supply has been constrained by stricter immigration policy and an aging population that allows kind of lower job gains to maintain that stable unemployment rate.
Avery Shenfeld: So certainly a good starting point for growth and employment and a bit of a troubling starting point for inflation justified both that move as well as the one that we&#8217;re forecasting for the next meeting. We don&#8217;t have the Fed hiking after that, but we do have some differences of opinion with the Fed&#8217;s forecast for 2027. They seem to have inflation coming down with virtually no pain in the economy and the unemployment rate staying at four percent. Our forecast is a little different than that. What are some of the differences there? And how do you think the US economy will in fact be shaping over the next couple of years in the wake of these Fed hikes? And what does that mean for what the Fed does down the road?
Helen Lao: Yeah, so there is a lot of uncertainty going into 2027. And you can see that in the summary of economic projection last week, that the dispersion of those dots for the federal funds rate projections were quite large. So I think it hinges a lot on the situation in the Middle East for oil prices, how that will evolve. So in our base case scenario, we assume that oil prices will stay elevated near the current level. Until the end of the year. And then we have it coming down gradually starting early 2027 to return to more kind of like a low 70s for Brent in 2028. So under that path, we will see inflation in the US easing in 2027 because of that coming down of the oil prices to get back to 2% by the second half of 2027. Growth, on the other hand, though we think could decelerate slightly in 2027. The two main forces I mentioned before, are resilient consumption and AI capital spending, we think both of those forces could lose some wind next year. AI capital spending is facing more and more fiscal infrastructure constraints, supply bottleneck issues, local resistance. And more recently, people sounding the alarm on safety issues and the pace of AI development being too fast. So we think while the level of AI capital investment will remain elevated for the next two years, the growth of it should slow. And we sort of already see some of that in the Q2 GDP investment data and components like computer equipment investment and software. On a year-over-year basis, those have actually decelerated in Q2. Consumption growth, we think, will remain solid, but still slow a little bit compared to this year. We think the wealth effect on consumption could start to dissipate as the wealth gains for those holding equities are increasingly being offset by a drag from real estate wealth as house prices ease in the face of elevated mortgage rates and slower demographic demand over the next two years. And also the effects of the temporary boost to income from the higher tax returns this year, that&#8217;s also going to be gone next year. So we expect growth to kind of ease modestly over the next two years. And for inflation, as tariff impacts and oil prices come down next year, inflation is expected to come down, starting really in the first quarter and reach about 2% by mid-2027. And that will allow the Fed to start cutting in the second half of next year and ultimately bring rates back to neutral in 2028. So let me turn the tables here, Avery, and talk about Canada. Do you think the Bank of Canada will follow the Fed with a rate hike? For Canada, the most important unknown at the moment is where our trade relationship with the US will land. What do you think will be the most likely scenario for trade talks? And how do you think the economy and ultimately policy rates will evolve in this scenario?
Avery Shenfeld: Well, it&#8217;s interesting that from financial markets perspective, if you look at the futures markets for overnight rates in Canada and the US, basically financial markets see it as monkey see, monkey do. The Fed is hiking, so therefore the Bank of Canada will be hiking. There&#8217;s about a little more than fifty percent chance priced in of a Bank of Canada rate hike in October, and about a hundred basis points priced out by the end of next spring, which would take actually rates a fair bit above neutral. And I think that that&#8217;s at odds with the fact that we&#8217;ve seen the Bank of Canada actually willing to chart its own course really over the past several years, including cutting interest rates more aggressively than the Fed, because the Canadian economy needed it. And you hit the nail on the head. Right now, the biggest problem for the Bank of Canada is that they are in no better position than anywhere else to really assess what&#8217;s going to happen on those trade relationships with the US. That&#8217;s unlikely to become clear at all by the time of their October meeting. There really are no talks underway now. We don&#8217;t expect to see formal talks until after the midterms. And so a wise course for the Bank of Canada in October, if they&#8217;re worried that inflation&#8217;s escalated due to oil, but that growth might decelerate a lot on the basis of trade frictions, maybe enough to do the work that rate hikes would otherwise be needed to do to slow the economy and prevent inflation from spreading, then their best course of action is to simply do nothing in October and wait to see what they learn about those trade relationships by December or even January of next year. Our view is that even in December, this may not be fully resolved. And then a lot depends on how this trade scenario plays out if we do get some sort of trade deal negotiated, I think one thing that was clear from the talks that broke down in August is that deal is not going to provide the kind of relief for the auto sector and the aluminum and steel sectors that we might have earlier hoped would be on the table. So we are expecting to see some sort of negotiated deal here, but it&#8217;s still going to leave some of those industries that got hit by a headwind in 2025, struggling to remain competitive and perhaps gradually losing North American market share as a result. What we are hopeful for, though, is at least that all the tariffs that were announced in August by both countries, as well as Donald Trump&#8217;s threat to impose a 50% tariff on autos and auto parts in January, that that all goes away in that set of negotiations. If that&#8217;s the case, we still see a headwind for the Canadian economy in 2027. And that&#8217;s the headwind from, as I said, those remaining tariffs on things like auto, steel, aluminum, and lumber. And so we did reduce our forecast by about a half a percent from what it had been earlier when we were more hopeful of getting a better deal that really did more to provide relief. But that&#8217;s a substantially different outlook. And I think this is a point we want to underscore from where we would be if nothing happens on the trade front. So you heard Governor Macklem yesterday talk about growth being cut in half in the fourth quarter because we&#8217;ve got these new tariffs being imposed. But I think we have to remember that there&#8217;ll be a further headwind right through 2027, not only from those tariffs, but the multiplier effects of job losses in those sectors. And the threatened tariff of 50% on the auto parts industry, for example, which would be devastating. So, I think that the Bank of Canada ought not to do anything until we get into the new year and we have some clarity. We&#8217;re hopeful that by the time they meet early in Q1 of 2027, we&#8217;ve got this trade deal either signed or very close to signed, in which case we may get a couple of rate hikes from the Bank of Canada in the first half of 2027. That will also depend, of course, on what&#8217;s happening to oil prices. Are they coming down? How quickly are they coming down? There might be room for the Bank of Canada to normalize interest rates a bit if we&#8217;ve made that progress on the trade side. And that&#8217;s ultimately what we&#8217;re assuming here. But where we differ a bit from financial markets is we don&#8217;t see the need to go beyond that two and three-quarters rate that the Bank of Canada estimates as neutral. In part because we have some doubts that the neutral rate is really that high, at least based on the evidence of what we&#8217;ve seen in sectors like housing and business capital spending, the sectors of the economy most sensitive to interest rates. We haven&#8217;t seen a lot of response to two and a quarter percent overnight rates. So our view is that yes, we may get to two and three quarters, but even if we do so, that will still be a bit less than what the market is pricing in. And we don&#8217;t have it starting as early as the market is pricing in. Simply because we think the Bank of Canada would be making a potentially huge mistake if they hiked interest rates now, slowed the economy, only to find out that there&#8217;s no trade deal and the economy is in fact too slow, and core inflation has lots of downward pressure from that widening economic slack.
Helen Lao: Yeah, so you just explained our base case scenario where there is potentially a deal. Now how would you see the Canadian economy and Bank of Canada policy evolve if we don&#8217;t get a trade deal with the US and if we don&#8217;t get a resolution of the oil supply shock in the Persian Gulf?
Avery Shenfeld: So that would be Tiff Macklem&#8217;s biggest nightmare, in effect, because we would have a slowing Canadian economy as a result of the trade shock. But at the same time, we might have quite elevated headline inflation, certainly above the two percent target. because even if we did start to get more economic slack, it&#8217;s going to be tough for that to pull inflation down. If oil prices are still escalating, because in the absence of a Persian Gulf deal, we&#8217;re going to see ever increasing shortages of refined products, diesel, gasoline, and so on. There&#8217;s no inventories that that we had over the past year, the strategic petroleum reserves have been drained and so on. It becomes very difficult for the Bank of Canada to steer the right course. They are an inflation targeting central bank, so they might do some rate hikes. But I think the only scenario where we get the kind of rate hikes that the market is pricing in, is a scenario where we get a really good trade deal. So Canada is recovering from these trade headwinds, and we don&#8217;t get any deal with Iran and any opening of the Strait of Hormuz and inflation is really escalating. That&#8217;s the one scenario where rates could get higher than our forecast. And the bottom line of all this, I think, of what we&#8217;ve talked about for both the US and Canada is you have to be as an investor or as a corporate treasurer or CFO playing with these different scenarios and thinking what risks you need to hedge about. Because just like those central bankers that are a bit in the clouds over where these various geopolitical events<a rel="noopener noreferrer">[UE1]</a>  are going to go, we as forecasters and our clients, either running companies or portfolios, are similarly operating behind those clouds of geopolitical uncertainty and making it very difficult therefore to stick with only a single scenario and really necessitates looking at different options, what risks they should hedge against.
Helen Lao: Thank you, Avery. So we&#8217;ll wrap it up here. But for those of you who want more details, check out the CIBC Economics website where we&#8217;ve posted our full forecast report. We&#8217;re calling this one the “Six Sided Die”, given the potential scenarios that we&#8217;ll face. Thank you for joining us for this edition of the podcast. Until next time, we&#8217;ll be keeping our eyes on the economy and calling it as we see it.
Disclaimer: The information and data contained herein has been obtained or derived from sources believed to be reliable, without independent verification by CIBC Capital Markets and, to the extent that such information and data is based on sources outside CIBC Capital Markets, we do not represent or warrant that any such information or data is accurate, adequate or complete. Notwithstanding anything to the contrary herein, CIBC World Markets Inc. (and/or any affiliate thereof) shall not assume any responsibility or liability of any nature in connection with any of the contents of this communication. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice. CIBC Capital Markets is a trademark brand name under which different legal entities provide different services under this umbrella brand. Products and/or services offered through CIBC Capital Markets include products and/or services offered by the Canadian Imperial Bank of Commerce and various of its subsidiaries. For more information about these legal entities, and about the products and services offered by CIBC Capital Markets, please visit www.cibccm.com. Speakers on this podcasts are not Research Analysts and this communication is not the product of any CIBC World Markets Inc. Research Department nor should it be construed as a Research Report. Speakers on this podcast do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned. The commentary and opinions expressed herein are solely those of the individual(s), except where the speaker expressly states them to be the opinions of CIBC World Markets Inc. Speakers may provide short-term trading views or ideas on issuers, securities, commodities, currencies or other financial instruments but investors should not expect continuing analysis, views or discussion relating to these instruments discussed herein. Any information provided herein is not intended to represent an adequate basis for investors to make an informed investment decision and is subject to change without notice. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice.

Rates, trade and oil: What’s next for the U.S. and Canadian economies?

CIBC Economics

Avery Shenfeld

Managing Director and Chief Economist

CIBC Capital Markets

Helen Lao

Executive Director, Economics

CIBC Capital Markets

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