Hello, and welcome to the Download. I'm your host Dave Richardson, and you can't see me today, but I am right here in late February, and I'm dressed in shorts and a T-shirt. And I've got a fan blowing in the background because everything economically that's been released this month has been red hot. It is a red-hot winter here in Canada, and who else better to explain what's going on than our favorite economist, the hardest working economist in Canada, by the way, Eric Lascelles, chief economist at RBC Global Asset Management. Eric, are you feeling the heat around your forecasting with some of these numbers that are coming out through the month of February?

Yeah. Hi, Dave. I'm feeling the heat on two fronts. One is that the data is hot. The other is that the data is hotter than I thought it would be. So that's heat in terms of me trying to make sure I'm on top of things and adjusting appropriately and understanding just what's going on. So, yeah, it's been quite a spell. And the January data coming out mostly in February has been really strong, I would say, for the US, most obviously. But Canada is ticking along as well. And we've talked before about how job numbers remain remarkably resilient, but the January numbers in particular introduced the notion that spending is still moving quite robustly forward as well. And so, US retail sales rose by 3% in January, and it would seem that everything was fitting together. We'd seen these nice— I shouldn't say nice, it's never nice; we're looking for a recession here and we think some cooling off needs to happen, and so I suppose only nice in that very narrow context— but nevertheless, we'd seen a couple of months of declining retail sales in November and December, and we just unwound it all with a big jump in January. You can definitely split hairs and say that January was a funny month. And it was, by the way, introducing a third concept of hot. It was hot from a temperature perspective and that often encourages more spending. So there might have been some artificial strength from that. It's fair to say that in a lot of countries, including the US and Canada, pensions got inflation adjusted in a big way for January. A lot of retired seniors saw huge increases in their nominal earnings. And so presumably some of that was put to work. There are a number of special factors that maybe aren't going to fully repeat in subsequent months. But nevertheless, we're still seeing economies that for the most part are growing. And I have to say that we've been tweaking our growth forecast in response to that. We still think a recession is likely, and I'm hoping we can get into why and all the central bank responses and otherwise that might be necessary. But I can say at the end of the day, we've pushed the recession timing back a little bit. So we had been thinking middle second quarter or third quarter of 2023, and we've now pushed that back to the second half. We're just not seeing the capitulation you would need to get there quite soon enough. But I would say at the end of the day, if anything, we’re actually a little bit more convinced that a recession needs to happen. In fact, in part based on the economic strength we're seeing recently.

Yeah, well, as you say about the pension increase, my mom is rolling around feeling rich. The grandchildren are the main beneficiaries and of course they do go out and spend. You can see that connection. But why don't we go to the main reason, the impetus of why we had you come on today, which was this morning— so we're Friday, February 24, taping this— and the PCE report was out this morning and once again a number that was hot. And this is a measure of inflation that is the Fed's preferred measure of inflation. Before we go into the number itself, what's the difference between the PCE and the CPI? The CPI tends to get bigger headlines in the general news. The PCE gets a little bit more of the headlines in the financial news, but the Fed prefers one over the other. What are the subtle nuances and why?

Right, the big difference, Dave, is that the letters are different PCE and CPI. No, I'm just joking. That is technically the difference. But no, there are differences beneath the surface. So, you're right, the CPI gets a lot of attention just in the broad public and that is because it is the older, the classic measure. There's one for just about every country in the world. You can compare across them. It's all very neat and tidy in that regard. I think it is worth watching. I spent a lot of time watching it, if I'm being honest. But equally that PCE deflator, which is the Fed's favorite measure, they say, does exist for a few other countries but it's primarily a US notion. And the big difference is just that it's a more flexible measure. It actually reflects the actual spending of consumers and so most of the time there aren't huge deviations between the two. But some of the time when you've got the cost of gas going up and people driving less and things like that, the CPI is stuck with a fixed basket that doesn't change all that often. It still pretends that everybody is driving just as much as before, even though they're driving less. It still pretends everybody is still buying steak even though food prices have gone up and we're all buying ground beef, and things like that. The CPI isn't as flexible to that. So maybe a bit less precise in terms of reflecting changing conditions, and the PCE deflator does do a pretty good job of picking that up. And so I would say that's probably the biggest difference. You can get into the weeds and say that the PCE deflator includes both urban and rural spending patterns, and the CPI actually is officially urban for whatever reason. And the PCE includes indirect spending. For instance, if you have health insurance in the US and you're paying part of your healthcare costs, but somebody else is paying the other part of your healthcare costs, the PCE deflator picks up the part that other people are spending on your behalf, the insurance company. And the health care portion of the PCE deflators is bigger as a result. Differences like that. But I guess at the end of the day, the PCE deflator tends to run a little bit cooler than the CPI and just for various reasons. As an example, you can say that in the US, inflation has averaged a little over 2%, if you're talking CPI, but it's actually been bang on 2%, over the long run, if you're talking about the Fed's preferred measure. Anyhow, more detail than you wanted. As it stands right now, as you say, we just got the January PCE deflator out.

Yeah, Eric, if I may jump in, I think it's a really important distinction, because as you say, one is more flexible. It reflects what's actually going on on the ground and does it in a more broader sense. For really serious economists, like the economists and the people at the bank of Canada and the Federal Reserve, well, we would hope that they're getting the best data possible to be making these critical decisions on interest rates. And of course, people like you as well, who are providing insights into how people should invest money. It's important that you have a measure that's a little more stable, a little bit more flexible, a more modern measure of what's actually happening with prices in the economy.

Right. True to form, the CPI for January came out and it was 6.4%; that's trending downward. The PCE deflator came out today, as we record this at least, and it was 5.4%. It's a full percentage point lower. So that story is holding, but it didn't fall, so it was a little stronger than expected. It actually rose from 5.3% the prior month and so all the various metrics, including the core side, were a little hotter than expected. We knew there was sort of a sniff of this coming because the CPI had also declined— I guess in its case, less than expected, and was above consensus. And so maybe at the end of the day, it's not a huge surprise that this number also isn't signaling that inflation problems are firmly over. But nevertheless, it was a little rougher, a little more worrying than the CPI. And so that's got tongues wagging about what central banks need to do, which might be to tighten a little more than otherwise. And so, the Fed had told us a while ago that there are likely a couple of rate hikes coming and that got you to maybe a 5.25 peak. But now markets— and I must say myself— we're thinking that there may have to be a bit more work than that to cool this economy off, to get this inflation under control. And so the market has almost a 5.5% peak policy rate penciled in right now, so it's had to add a little bit more. And of course, the stock market, as much as it generally likes good economic news, doesn't like it when it's just an overheating economy that needs to cool. And it most certainly doesn't like it when inflation is too high and central banks have to do more work. And so the stock market hasn't been entirely pleased with the recent economic strength and it raised debates about— the debate before was soft landing versus recession— do you weaken but avoid a recession versus tumbling fully into a recession this year? And now there's a camp saying maybe there's a no-landing scenario in which the economy just keeps trucking along. I'm personally skeptical. I mean, I guess it's sort of happening in the very short term, but I'm skeptical that can be a story that would persist over the span of a full year because it seems pretty profoundly obvious to me that we have economies, particularly on the labor market side, that are just overheating to an ever-greater extent and to an extent central banks don't like that. And indeed, the parts of inflation that are still refusing to cooperate are mostly service side, notwithstanding an increase in gas in January. In most of those service sector portions of the economy— or inflation portions of them at least— are very much linked to the strength of the economy. The best predictor of what service inflation is going to do is how hot the economy is, to a greater extent than other items of CPI or the PC deflator. And so central banks are making clear the economy just needs to be cooler to get inflation down in these areas. And so that's their mission. I think they’ll eventually succeed in cooling the economy. And so I find myself skeptical of the no-landing scenario, but nevertheless, in the very short term, we've had some real strength here and central banks are scrambling again. Dave, let me say that I can still return to our original inflation framework, which is that we do think it can fall this year. Indeed, it is profoundly down from where it was in the summer and fall of last year already. We do still see the big four things all turning. The commodity shock has faded, and the supply chain problems are easing, and central banks have reversed with aggression. And fiscal policy is at least not what it was, if not truly restrictive. And so that should allow inflation to come down. We're just not getting the cooperation of the economy as the fifth extra factor at this point in time. I'm still very happy to forecast inflation comes down. I even think it could come down a little faster than the market thinks. But January didn't fully cooperate and it's clear that we do need some more forces to cool the economy. I will say— sorry, this is me now going on too long; this is meant to be a conversation— but I will say on the recession call side, it was never a certainty. It's still not a certainty. We've pushed back the timing. I think that's appropriate given what we're seeing. But keep in mind we're getting potentially even more monetary tightening now and so that's an additional argument for weakness. We are seeing negative effects from prior rate hikes. The housing market has weakened quite a bit and other rate-sensitive sectors are softer. One thing we're really tracking right now— and it relates entirely to the credit market— is loan officer surveys, both in the US and in Europe. The willingness and the standards are tightening a lot with regard to commercial and industrial loans, and to a point that you never see without getting a recession. And so I would say we're still seeing the various effects of higher rates working their way through. I still think it's likely we do get to a recession, unfortunately. We've got a little more work to be done before we can right size the economy and get inflation back on track.

Yeah, we keep it real on the download, Eric. So this is what our conversations do sound like. So it really is a conversation. I just kind of wind you up very quickly and then you go. But Eric, there are some underlying signs. Like you said, the loan officers— and I know here in Canada our standards are always pretty tight—, but the government has done a lot of things over the last few years, regulatory wise, to tighten that up a little bit more. And then you look at things down in the US, for example. A lot of cash put into the system that people went out and spent. That may be running out because now we're seeing the highest levels of credit card balances in the US that we've ever seen. This is a sign that people are still out spending. And they have to; you got to put food on the table, you got to do some things. But some of that excess liquidity in the system, so to speak, is getting tapped out, I think.

I'm no corporate analyst, but you look at some of the recent reports from major retailers that show pretty muted expectations for the year ahead. So that's their best guess. And spending patterns seem to be continuing to evolve in a way in which it's the cheaper stores that are holding on and the more expensive ones are already suffering. So people are downgrading where they're spending and maybe the quality of goods that they're purchasing. We're seeing little bits there, as you say, on the credit card side. Credit card borrowing in the US is up 15% over the last year; a pretty fast growth rate. So that's people for the moment continuing their spending patterns but in a way that isn't being fully supported by their incomes. And that sounds unsustainable to an extent. Similarly, personal savings rates have come down. They were so high initially in the pandemic and some of that money, as you say, is just being spent through and that's entirely allowed. But nevertheless, savings rates are now pretty close to as low as we've seen it over the last 50 to 70 years and that's not indefinitely sustainable. And even though we can still say, listen, there might still be a trillion plus dollars sloshing around more than usual, it's not equally distributed; it's disproportionately among wealthier households who may not spend at all. They tend to save just enduringly a greater fraction of their wealth. And so, there are absolutely people bumping into restrictions. I can't say I see it yet all that much in terms of credit card delinquencies or auto loan delinquencies or mortgage delinquencies. Those are looking okay, though a couple of those are at least bottoming out after a happy decline. But again, the theory is pretty sound here: when you raise rates by 4, 5, 5.5%, that's a big hit to the economy. That should induce a recession. And our business cycle work says it's still likely, and our various heuristics and inverted yield curves and things still say it's likely. It's clearly not happening quite yet early in 2023 and that's fine. Often these things do have long and I guess variable legs as well. But again, the no-landing thesis to me is a stretch. I don't see how that happens, especially as we now have central banks potentially set to do even more tightening than previously envisioned.

Well, I just like to tap everyone on the shoulder who's listening and remind them of something that you've taught all of us on your previous appearances: when you're talking about a data set going up and coming down, it's never a straight line up and it's never a straight line down. You're going to have pauses, fits and starts along the way. And there's usually some kind of data that you look back on in hindsight or you can even see in real time that says, hey, the number is a little hotter than we thought, but there's an explanation for it. And it leaves our overall thesis in place that, as you say, if the central banks, the Federal Reserve in particular, wants to slow down the economy and they're committed to it by raising rates, then that is going to continue to happen and they're going to get the slowdown that they want. So ultimately, this plays out even if it goes a little bit higher in terms of where rates top out and a little bit longer in terms of how long those rates have to stay there before they start coming down. And then, of course, the market looks at that, makes their interpretation, and does what it's doing. And as we talked with Stu yesterday, it seems to be saying, hey, we're going to take a pause and wait to see where this goes before we go any higher here.

Yeah, and I don't think I'm out of step in saying as a firm, we are still cautious relative to where we were a year and a half ago, taking fewer risks in markets than before. If anything, we viewed in particular over the last few weeks as markets have begun, I think to awaken to a thesis we've talked about for a while, which is, hey, there was a lot of really good news that came down the pipe between October and recently. And I guess you could maybe say some of it continues in this purely economic data context. But it's still a tricky world out there, and inflation is not fully solved, and central banks aren't done, and the economic outlook still does include a recession. And so, we're happy to be even a little more cautious as it pertains to risk assets in the near term. The long-term valuations are good for just about anything you look at compared to where we've been in the last 15 years, which is lovely, and it's not a bad way to invest on that basis either. But if you want to get cute, you can say, well, there are still some risks to risk assets in the near term.

Eric, I just wanted to ask you one more thing before I let you go today. As Canadians, we recognize that what's going on over the border in the US is more important, or it has a massive influence on what's going to happen here. So we're sometimes a victim or beneficiary of what's happening there. But the bank of Canada, as we've talked about before, is trying to take a more cautious course in terms of raising the bank rate. It seemed like on the last increase that they were signaling a pause. Is the fact that the US is likely going a little bit higher than we would have thought two months ago, is the bank of Canada going to have to break and follow, or will they be able to hold?

That really is the debate. The bank of Canada has been I wouldn't say firm, but it's been clear at least in the sense that its default assumption is that the work is done, and 4.5% is the peak rate. And I'm very sympathetic to the idea that, with a greater level of interest rate sensitivity in Canada and more extended housing market and so on, the peak policy rate doesn't need to match the US whatsoever. And indeed, even if we weren't more leveraged, just the fact that Canada has floating in variable rate mortgages and five-year terms and these sorts of things means that the effect of rising rates hits us sooner and more profoundly and it's harder to renegotiate a mortgage here. And so in a number of ways, the rate hikes that have happened are already there. I think it's quite plausible the bank of Canada is done. I will just tell you that the market— I'm looking here at the implied probabilities in the market right now— has priced in almost another rate hike, but not until September incrementally. So the market is hedging its bets here, thinking, well, it's not likely there's a hike next time, not all that likely the time after, but maybe somewhere out there over the next six or seven months, there could be 125 basis point rate. I think that's about where we are. No one's really debating that there's another percentage point that's needed. If they're going to move in the next six months, it's up, not down, in all likelihood, but if they moved, it wouldn't be by a whole lot. And I think that's probably the way to leave it. It doesn't seem as though they're signaling much for the March 8 meeting as an example.

I have to say that the bulk of our listeners are in Canada. Many of them are involved in the real estate market or they’re business owners. So we should come back in and check in on where the Canadian policy is somewhat diverging. And we've talked about this a lot. If you go back and listen to previous episodes of Eric's appearances on the podcast to draw the distinction and why that might happen. So Eric, as always, thanks again. You're always open to getting on when something interesting has happened or a particularly interesting number pops out and is announced on a given day. So thanks again and we'll check in with you in a couple of weeks on the next labor reports.

Fabulous. Thanks so much, everybody. Thanks, Dave.