‘Sticky’ inflation means higher interest rates could last longer than expected: Bennett Jones report

Economic outlook by advisers David Dodge and Serge Dupont says higher interest rates to slow growth

‘Sticky’ inflation means higher interest rates could last longer than expected: Bennett Jones report

While the key Bank of Canada rate is likely at, or near, its peak, former Bank of Canada Governor David Dodge, now a senior adviser at Bennett Jones LLP, says he does not expect any loosening of monetary policy in 2023. And rates will likely only come down gradually in 2024 and 2025, depending on the “stickiness” of inflation.

The result is that high interest rates in the U.S. and Canada (with the U.S. federal reserve rate now at 5.25 percent and the Bank of Canada rate at 4.75 percent) will cool down the economies of both countries.

Dodge, one of the authors of Bennett Jones’ economic outlook Playing the Long Game, said at a recent webinar for firm clients noted that from the second quarter of 2023 to the second quarter of 2024, real GDP will grow at annualized rates of 0.8 percent in the United States and one percent in Canada.

Expectations for slow growth, if not recession

“What does this outlook for monetary policy imply for growth in both countries? The short answer is that a period of very low growth, but not necessarily a recession, is needed in the second half of 2023 and early 2024 to curb excess demand and bring inflation down.”

With inflation then on a downward track, allowing for interest rate cuts, growth would firm up to an annualized average of 1.9 percent in the United States and 2.5 percent in Canada by the end of 2025.

The report says that “getting inflation back to target—for Canada to the middle of the one percent to three percent band—will not be an easy task.” It notes that price inflation for services is “persistent,” and wage pressures could accentuate it.

“Even in our baseline scenario, headline inflation will be slightly above two percent in Canada by the end of 2025.”

By this time, central bank interest rates would range from three percent to 3.25 percent in the United States; and 2.75 percent to three percent in Canada. Ten-year government bond rates would be about 3.25 percent to 3.50 percent in the United States and 3.0 percent to 3.25 percent in Canada.

The report also points to risks in this scenario. “If global developments cause new stress, or if inflation is stickier than expected, there could be a recession, but more likely a prolonged period of low growth and adjustment.”

After decades of falling real interest rates, the report says there is reason to expect that even when inflation is back at target, nominal and real interest rates will be higher than pre-COVID. But Dodge told webinar participants that keeping inflation at bay is much better than letting it grow, pointing to the days of high inflation in the 1970s and 1980s.

“We spent 15 years from 1970 to 1985 with that,” he said. “We don’t want to return to the sort of conflict in our society that comes from a period of high inflation.”

Giving clients guidance on economic and business issues

At the webinar outlining the contents of the report, moderator Claire Kennedy said, “One may wonder” why a law firm produces economic outlooks twice a year.”

The answer, she said, is “we work with clients on their most complex legal matters - to plan to manage risks to make decisions.” Clients need expert legal advice, but they also need context, including “reasonable planning parameters for the short term, and appreciation of structural trends, global and domestic, that define risks and business opportunities, and a narrative that ties all this together to make sense of complex systems.

The report also points out some trends that should dispel recent concerns over a shortage of workers in coming years. “Over the past years, the demand for labour from employers has grown faster than the supply of labour, such that labour markets have tightened. This is manifested in a historically low rate of unemployment and a high job vacancy rate.”

However, “over the next decade, taking into account demographic trends and planned immigration, the supply of labour will grow fast enough to meet demand.”

The greater task will be equipping workers, including immigrants, with the “right skills” to ensure the needs of employers and raise productivity levels. “While it is sensible that immigration policy helps address current labour shortages, this cannot obscure the fact that unless economic immigration brings high-skilled workers, it will not help raise income per capita.”

At the webinar, Dodge emphasized that “while immigration is extremely important, an excessive reliance on immigration will, in fact, lead to a low productivity, low growth economy.”

Making the case for Canada to invest more in capital

On the bigger picture of economic growth going forward, report co-author Bennett Jones senior adviser Serge Dupont, who held many federal government positions, including Deputy Clerk of the Privy Council and Deputy Minister of Intergovernmental Affairs before joining Bennett Jones in 2018, noted at the webinar that trade “trade is no longer the same engine of growth for the world.”

Openness to trade and investments in skills specialization are important ways to raise productivity, he said, but the world is “becoming more complex and more fragmented” as the World Trade Organization is “in retreat” and there is a “multiplication of bilateral or plurilateral deals.”

Still, there are opportunities to grow markets. For Canadian businesses, that means taking advantage of under-utilized trade agreements with the United States, Mexico, the European Union, and some of the most robust and dynamic Asian economies.

Dupont also noted that Canada under-invests in capital. Non-residential investment, as a proportion of GDP or per worker, is below the historical average.

Compared with the United States and the average of Organization for Economic Cooperation and Development member countries, Dupont said our “investment gap is large, and it has widened over the past years.”

The gap compared with the US and the average of other OECD economies, Dupont said, is two to three percentage points, or up to $90 billion of investment per year.

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