Hello and welcome to our latest video #MacroMemo. And as always, lots to cover off. We'll spend a moment on COVID-19 and some of the improving trends for the most part there. We'll talk about the war in Ukraine and the natural gas price situation. We'll discuss inflation scenarios for a moment. So just contemplating scenarios that are different than our base case.

We will discuss shrinkflation. So the underappreciated source of inflation that's a bit sneaky and not all that easy to observe. We’ll discuss soft versus hard data. We'll talk about a debate in the labour market; we’ll acknowledge and maybe more precisely quantify Canadian housing market weakness. And we’ll acknowledge what central banks have been up to. And as I say, all that it seems like an awful lot.

And so let's just jump our way right in and on the COVID file. Well, COVID numbers are actually improving across most of the world right now. It's no longer the central driver for economic activity or markets, but we are seeing substantially more improvement than deterioration right now, which is good. We have Omicron targeting vaccines that are becoming available right around now. And so that's of course, a positive as well.

It's notable that we have not seen a more contagious variant than the BA.5 sub-variant in quite some time. And so one still presumes there will be more eventually, but it's still a positive thing, as that's one of the key drivers of future waves. And so generally it's been a good news story with, of course, the constant exception of China, which has a zero-tolerance policy and has gone back to some fairly significant locking down recently.

And so the large city of Chengdu was recently locked down. It has 21 million people. In fact, by some estimates, there are now 70 Chinese cities with more than 300 million people that have been either fully or partially locked down just since late August. And so it's worth recognizing that China has a national Congress coming up in mid-October. And so there's a push to get everything as perfect as possible, including minimizing COVID cases. Presumably, they will be a little bit less diligent after that. But nevertheless, some short term economic damage to China on the back of those lockdowns.

On the subject of Ukraine and the war in Ukraine, well, there's been a recent reversal. So the story really for most of the last six months has been Russia gradually claiming Ukrainian territory. And there was a significant pushback in the last week, at least as I record this. Still fairly slight should be acknowledged in the grand scheme. You can mount the argument that the tables should start turning in favour of Ukraine as weapons continue to flow in, as Russia starts to run out of certain munitions. But the war is far from done.

The outcome, frankly, still isn't all that certain. And from an economic standpoint, the sanctions still remain. And that's the relevant constraint on the global economy and particularly on the European economy. Indeed, you can say trade restrictions are actively rising. If anything, Russia has now fully cut off its natural gas supplies, at least through the Nord Stream 1 pipeline to Europe and one estimate is now approximating that the EU will have to spend about seven times more than normal on electricity and gas over the next year.

That's an extra $1.2 trillion, which is quite a lot. And of course the hit has been felt particularly by households and businesses. In fact, that's a notable comment, simply because we're now seeing governments jumping in. And so European governments, now the UK government, are throwing together quite large subsidy programs. They're not going to eliminate the hit, but they will soften the blow of higher energy prices to European consumers and to an extent European businesses.

And so this has several consequences. It reduces the amount of inflation we should expect at the consumer level. Still going to be quite high, but a little bit less high. It is quite costly, of course, for government, so it adds to fiscal coffers. It does unfortunately reduce the incentive to conserve. So demand will be higher than otherwise because people can afford the energy more than they would have.

And it's going to be hard to remove later. In fact, the UK and the new British Prime Minister Liz Truss are proposing a 2 year plan. So they've already promised two winters worth of support and so that's going to add up indeed if this lasts across multiple winters. But in any event, from a private sector perspective, the damage from high natural gas will be somewhat.

Let's continue down the inflation path. And so, on inflation, inflation scenarios. Well, our basic view is still that inflation becomes less high over the next six months and indeed decelerate somewhat over the next year as well. The August numbers for the U.S. just came out and they were indeed considerably softer than the norm of the last year, if not quite as soft as the market had expected.

And so when we think about the likely outcome, say, for the next six months, we think it's most likely inflation, as I said, gets less high. We're assigning about a 55% chance to that. I guess the question remains, though, what is the other 45%? And so clearly there's a chance that inflation just stays too high. That's a real chance.

We're giving a 20% chance to that. But I want to flag that we think there's actually a 25% chance, a slightly better chance that inflation actually ends up a bit too low over the next six months or so. Not to say the annual figure is too low, but just the monthly trend ends up being very soft to the point of perhaps even flirting with falling prices across certain months and the idea behind that is really just, I guess in part that this is, I think, underappreciated by the market, that there is a temporary deflationary scenario out there.

And in terms of why that might be the case, well, keep in mind, commodity prices went up a lot. To the extent a recession happens, commodity prices have already come down somewhat. They could go down quite a bit more. That would be outright falling prices from that source. It’s very similar for supply chains. Supply chains as well were very problematic.

Costs went up a lot. Supply chains are getting a lot better. Those costs shouldn't just be flat from here. They should be actively falling. If we get a little lucky in terms of other drivers, that could be deflation for a period of time. And so it's worth flagging there is a low inflation scenario as well, as much as just decelerating, we think is the most likely scenario.

Further to the inflation discussion but with a different twist. Shrinkflation – this is a concept you may or may not have heard of, but shrinkflation is the idea that instead of raising prices, companies can sneakily shrink the size of their products and kind of achieve the same ends, can make more money, or at least not lose money in a rising cost environment. And of course, it's harder to observe this.

And this has been happening. So, for example, Gatorade recently shrank its bottle from 32 ounces to 28 ounces with the same price. That's a sneaky 14% price increase. Domino's Pizzas’ chicken wings have gone from ten wings to eight as an order. That's a 25% price increase. So we're seeing things like that. Normally, it's a small effect.

The effect, though, is somewhat bigger often during periods of high inflation, which is where we are right now. It does tend to be focused on food and drink and confectionery items and that kind of thing. And I guess maybe the most important comment, though, this is picked up in the official inflation data. The official inflation data is adjusted for units for the size.

And so that gets picked up. But maybe it doesn't get well reflected by you and I as we're buying things so that's what makes it relevant. It's also worth mentioning skimpflation, which is more or less the equivalent concept for the service sector. So you can think of, for instance, a hotel room. You no longer get it cleaned every night in the post-pandemic era.

That's some diminishment of service, and yet you're maybe paying the same price, if you're lucky, for the hotel room. And so there's some sneaky extra inflation in there that doesn't get properly picked up in the statistical data. Inflation is running a little higher than it looks like on the basis of that.

Okay, let's talk economy for a moment. Really just the observation is going to be soft versus hard data. So soft data refers to surveys. Hard data is actual spending and hiring and deployment of resources. And the soft data, that is to say the surveys, have weakened a lot – that's been well-established. Hard data hasn't weakened as much. That is to say the spending and hiring and so on has held together somewhat better.

Case in point, U.S. payrolls were up more than 300,000 jobs recently. U.S. third quarter GDP looks like it should be a fairly moderate positive figure. We expect the hard data to eventually follow the soft data and to weaken. So that's the most likely scenario I think. And there is a natural lead and lag relationship between the two. But it's fair to say that the soft landing scenario and I'll admit I'm using the word soft now in a completely different sense just to confuse you all.

But the idea that a recession might be avoided in a lucky scenario, a lot of that comes down to the idea that maybe consumers aren't feeling so good, but they just for some reason keep spending. And that has been to an extent the experience so far. So let's keep watching that. I think we will see some weakness, though.

On the labour market. Well, this labour market debate, and it really applies to many countries around the world, including the U.S. and Canada, is just the extent to which we'll actually see significant job losses or not as the economy softens. So optimists argue that job openings are so high that companies can just reduce their hiring plans without firing anyone, and significant job losses and significant economic pain can be avoided just as the labour market normalizes.

Pessimists say there's no precedent for that happening. Anytime job openings come down, unemployment rises and anytime unemployment rises, you get a recession. And so in the end, you're likely to see some labour market suffering. We land in the middle, to be honest. And so we do expect the unemployment rate to rise. We do think a recession is more likely than not.

However, from the beginning, we've been saying we think there’d be fewer job losses than normal just because yeah, some of the adjustment to the labour market can come via companies just hiring a little less as opposed to firing a little more. But still assuming some labour market weakness. Okay, we're getting close to the homestretch here.

So Canadian housing weakness. Well, really, the comment here is just that everybody knows the Canadian housing market has been soft, but there's some confusion in terms of just how soft it has been. And we were looking at different measures of home prices. And they say either that Canadian home prices have fallen by 17%, by 10%, by 0.3% or not at all from their peak earlier this year.

So there's some contradiction in that. When you dig into the details and suss out which is perhaps the best metric, the conclusion is that the measure that says home prices are down by 10% seems to be the best of the bunch. And it's a more accurate representation, we think, of what's going on. So that's our final answer.

We're sticking with it for now. We are saying, though, that we think home prices do have some further distance to travel as mortgage rates rise. And so we've been predicting a 20 to 25% cumulative price drop. And so you could say we're at best halfway through the decline, perhaps a little bit short of that. So we do expect some weakness left to come.

And then lastly, on the monetary policy front, well, nothing really surprising here in the sense that central banks are still raising rates. They're still raising rates quite a bit. The Bank of Canada hiked its policy rate by 75 basis points quite recently. The European Central Bank did precisely the same thing, which is a big deal for them. They are now out of negative, out of zero territory into a positive rate for the first time in the better part of a decade.

The RBA in Australia raised rates. Looks like the U.S. Fed will raise rates by 75 basis points shortly and that's quite a big-sized increase. Maybe one interesting comment and just irrelevant particularly in the Canadian case but perhaps applicable to others is that Bank of Canada starting to slow down a little bit.

They raised rates by 100 basis points in July. They raised rates by 75 in September. Their signaling suggested a little less urgency for the future. Rest of the market is thinking it could be 50 basis points in October, could be 25 basis points of tightening in December. And so that's a pretty clear decelerating trend here. Things could yet change, but I would say that's not a bad guess.

So that would leave the Bank of Canada policy rate peaked at around 4% around the end of this year. And indeed, we're not at peak policy rate yet, but we are maybe past the point of peak tightening. The velocity is starting to slow, and that's a little bit of consolation. Though of course, there still is some economic damage left to be felt by the tightening that's already happened.

Okay, that's it for me. Thanks so much for sticking with me and consider tuning in again next time. Have a great week.