February 7, 2023 | macro-economic research report

Research Report: A Conditional Pause

BY: Richard Croft
The Bank of Canada (BoC) is out front once again. The BoC was the first of the G-7 central banks to deliver outsized rate hikes early in the cycle and is now the first to signal a pause after raising the overnight lending rate by 25 basis points (0.25%) on Wednesday January 25th, 2023. The BoC’s overnight lending rate now stands at 4.5%, a 15-year high.



The Bank of Canada (BoC) is out front once again. The BoC was the first of the G-7 central banks to deliver outsized rate hikes early in the cycle and is now the first to signal a pause after raising the overnight lending rate by 25 basis points (0.25%) on Wednesday January 25th, 2023. The BoC’s overnight lending rate now stands at 4.5%, a 15-year high.

In support of the “conditional” pause, BoC Governor Tiff Macklem offered a comforting thesis that inflation would come down quickly from the current 6.3% annual rate to something near 3% by mid-year. Notes Macklem, “it takes time for higher interest rates to work through the economy to slow demand and reduce inflation.” The implication is that the BoC wants to weigh the economic impact of the aggressive rate hikes (more than 4% in less than a year) it has already made. The overall objective of this policy is to slow demand without causing a major recession.

There is reputational risk in this decision. If the BoC is wrong about its soft-landing thesis — i.e., if inflation stays stubbornly high, or the economy tumbles into a deep recession — it will be Macklem’s second major forecast error in his less than three years on the job. According to Bloomberg, he is already scorned by some Canadians for his actions during the pandemic, when he assured rates would stay low for a long time, prompting some to take on jumbo variable-rate mortgages to buy homes that are now dropping in value.

The financial markets’ fixation with the “pause” rhetoric rather than the actual rate hike has resulted in higher equity values, which bolster the wealth effect that could cause a spike in demand. Macklem attempted to tamp down that concern with his “conditional” caveat. Which is to say the rate pause is conditional on economic data “evolving broadly in line” with the central bank’s Goldilocks scenario —and two or three quarters of stalled growth without a major increase to unemployment and a return to 2% inflation by the end of 2024.

Macklem’s approach to telegraph the BoC’s stance on future rate plans has been standing operating procedure since he became Governor in June 2020. We think his willingness to risk another reputational hit adds weight to his forward guidance this time.

Looking at the bond market, it appears that market participants are taking his stance as gospel. The bond market is inferring that the BoC will hold rates steady for some time as, at the time of writing, two-year Canada bond yields have tumbled from around 4.3% to 3.57%. More importantly, Government of Canada two-year bonds are trading at a 55 basis points (0.55%) discount to comparable US Treasuries. That is an about-face from where they were just four months ago, when Canadian yields were trading at a premium to US rates.

While this “conditional pause” marks a major shift in monetary policy, it should not come as a surprise. Eight straight rate hikes over the past year have been difficult to swallow as spiking borrowing costs have hammered the housing market, which is more influential to Canadian GDP than it is in the U.S.

As price pressures ease and the economy stalls, the BoC governing council believes that interest rates are likely as high as they need to go. Underpinning that position is a forecast that, with ultralow unemployment, the Canadian economy will likely experience two or three quarters of slightly negative to slightly positive growth that may indicate a mild recession but will not likely herald a major contraction.

We are reminded of the story about a man who jumped from the 80th floor of a high-rise where people asked him how things were going on the way down. The answer “so far so good!” The same can be said for the Canadian economy… so far so good. Bolstered by near record low unemployment and better than expected GDP growth (based on fourth quarter 2022 data) the BoC considers the Canadian economy in a state of excess demand.

Demand is expected to dampen as homeowners renew mortgages at much higher rates. Mortgage interest payments are expected to capture 4.5% of disposable income at the beginning of 2023, up from 3.2% at the beginning of 2022 according to the BoC’s quarterly Monetary Policy Report.

It is not surprising then, on the heels of four-decade-high inflation, that Canadian consumers are cutting back on big-ticket purchases. The continuing impact that higher mortgage rates will have on disposable income should further dampen spending as nervous shoppers cut out non-essential items.

If the BoC forecast is correct, it raises the possibility of a pivot, which is to say rate cuts in the fourth quarter to counter slowing economic activity. Currently, financial markets are pricing in at least half a percentage point rate cut by the end of the year.

In the next few months, while rate cuts are not on the table, rate hikes are also unlikely unless the BoC observes evidence that inflation and economic growth are overshooting the bank’s forecast. As an end game to our “so far so good” analogy, we note that Australian CPI recently re-accelerated, likely the result of China’s re-opening, which is Australia’s major trading partner.

The U.S. Federal Reserve (Fed) is clearly concerned about the prospects of re-acceleration, which is why another 0.25% (25 basis points) rate hike is likely. The Fed believes it is better to risk a recession than chance re-acceleration of inflation. What this tells us is that we are making investment decisions in an unusually uncertain environment.


One of the more remarkable counterweights to Putin’s war in the Ukraine has been the resilience of western economies in dealing with the political and economic shockwaves propelled by the invasion. The most pronounced shockwaves hit the energy and agricultural complexes. Western sanctions and Russian restrictions on the movement of Ukrainian grain caused an immediate upward spike in the price of energy, food and fertilizer. But now, after a surprisingly short amount of time, these economic shockwaves are dissipating.

According to the latest U.S. inflation data, food prices are receding after their initial spike. Fertilizer prices, which take time to feed into the food component of U.S. CPI, are less today than at the beginning of 2022. The same is true for energy – at the end of 2022 the post-invasion surge in oil prices had contracted below pre-invasion levels.

That the world was able to mitigate much of the pain is a testament to the West’s power to manage turmoil when the private sector and governments work together. U.S. energy companies ratcheted up production and were able to increase exports of natural gas as production of petroleum products surged. The U.S. government also sprang into action by releasing 200 million barrels of oil from its strategic reserve, and Europe sought new energy deals with Azerbaijan, Algeria, the UAE and others. Additionally, Europe sought to reduce their future reliance on Russian energy by encouraging the construction of liquified natural gas terminals to take in foreign gas.

Countries set in motion conservation strategies that encouraged consumers to reduce their energy footprint in the face of higher prices. Americans eased up on their travel over the summer, a mild winter allowed Europeans to turn down their thermostats. Governments strengthened their resolve to find additional sources of renewable energy. Some countries extended the life of nuclear plants that were due to be shut down, and in some cases despite the environmental impact, increased coal output.

Lower prices for oil and natural gas benefited the agricultural sector as natural gas is a key ingredient in the production of fertilizer. As natural gas prices receded, so did the price of fertilizer. In time that will impact food prices at the consumer level.

Farmers need petroleum to run equipment and transport products, so falling oil prices are already showing up in food prices at the production level. To manage shortfalls caused by Russia’s restriction on Ukrainian grain shipments, farmers planted more crops. Additionally, some Ukrainian grain was able to get to market after the U.N. helped broker a deal whereby Russia has allowed Ukrainian exports on condition of inspections in Turkey.

Another factor was luck. Because we are experiencing an unusually mild winter there was less need to utilize limited reserves for heating allowing farmers to expand production and generate above-average crop yields. Finally, western sanctions included some carve-outs that allowed some Russian oil onto the market if prices were capped at US $60 per barrel. While these carve-outs limited the West’s ability to curtail Putin’s war chest, it meant that with Russian exports of energy, fertilizer and food, the impact on global demand was less than expected compared to when the war began.

Still, exports from Russia and Ukraine did take a serious hit last year, which undeniably administered a massive shock to the global economy. But political leaders and the invisible hand of capitalism did their jobs as expected. The fact is that, in less than a year, prices have begun to normalize and the world has largely absorbed the Russia shockwave.


If we were to grade the Chinese economy based on what we know, the opportunities appear limitless. Government efforts to build infrastructure, encourage foreign investment, enhance competition within a low-wage environment, have solidified China’s role as a manufacturing behemoth.  China’s labour force has a deep-rooted work ethic making it fertile ground for foreign entities seeking to transition labour-intensive manufacturing offshore. By the end of 2019, China accounted for 28.7% of all manufacturing output and had become the nerve center of global supply chains.

Prior to the onset of the COVID pandemic, China was the poster child for globalization. Profit margins improved on the back of lower production costs and improved supply chain efficiencies resulted in a prolonged period of disinflation.

When low wage economies export to high wage countries, there is an immediate disinflation impact as the flow of lower-cost goods and services is directly channeled into producer price inflation (PPI). One 2008 study by Swiss National Bank found that between 1997 and 2006, trade with the ten lowest-wage countries reduced U.S. PPI by approximately 2% per year. China accounted for half of that total effect. While the PPI is more volatile than the Consumer Price Index (CPI), the advantages and disadvantages eventually pass through to the end consumer, which is why over long periods, there is a high degree of correlation between the PPI and CPI.

From 2000 through to the end of 2019, the benefits of globalization flowed into the coffers of multi-national corporations and western economies which, notwithstanding the 2007 through 2009 global financial crisis, experienced unprecedented real growth. On the flip side, globalization explains the U.S. CPI’s sensitivity to global factors.

As more countries bought into the globalization manifesto, the Chinese economy vaulted into top spot in terms of manufacturing. Today most major economies rely on China to produce intermediate goods in the supply chain. By the end of 2018, there were thirty countries where China impacted at least 10% of domestic consumption (i.e., imports plus exports of goods and services). In 1999, Hong Kong was the only country where China had such a marked impact.

While exports initially supported China’s exponential growth trajectory, it also created a thriving middle class that, in the current environment, is a major contributor to GDP. Exports as a percent of China’s GDP have fallen from a high of 37.2% in 2006 to 19% at the end of 2021. The shift from reliance on exports to domestic consumption empowered China in a way that makes it now look more like an adversary than a partner.

And there lies the rub! When formulating an investment thesis, it is critical to recognize the impact of the factors that we don’t know and, in many ways, are unknowable. As a case in point, we can recognize the historical link between globalization and disinflation but cannot possibly know how China’s zero-COVID policy and the Chinese Communist Party’s (CCP’s) relationship with Taiwan, will impact near-term inflation.

The zero-covid strategy clogged supply chains and elevated production costs. It also lead to heightened political rhetoric as China’s reliance on exports abates that allowed the CCP to re-evaluate the risk and potential from a more aggressive posture.

As China reacted to rising tensions among the middle class, it has moved away from its’ zero-COVID policy and allowed the economy to reopen. That should have an outsized benefit for multi-national companies with a domestic presence such as Tesla, Apple and Starbucks.

However, transitioning from the zero-COVID strategy was not without its challenges. Going from lockdowns to open borders in a society with low COVID immunity is fertile ground for an explosion of unintended consequences. Recent data (as of February 2, 2023) from the World Health Organization (WHO) list 2,023,904 confirmed cases of COVID with 84,190 deaths. Most health experts believe these numbers vastly undercount the actual total.

Re-opening the Chinese economy is not a one-sided exercise. COVID lockdowns contributed to declines in domestic demand which had a marked impact on China’s GDP. On the other hand, declines in domestic demand reduced inflationary pressures, particularly in the price of Brent crude oil. The International Energy Agency (IEA) August 2022 Oil Market Report estimated that Chinese oil demand fell 2.7% year over year (y/y) in 2022, its first annual drop in oil demand since 1990. That same IEA report estimates a 6.5% rebound in Chinese demand in 2023.

Tech Tensions

A second near-term risk – to both inflation and risk assets – is the increasingly hostile relationship between the U.S. and China. For the past six years a deterioration of this relationship has resulted in inflationary policies that began when President Trump utilized tariffs to exact a more level playing field. The trade war has since expanded into a Cold War, with technological leadership at its center.

President Biden has maintained lines of communication with President Xi but retained a strong hand when it comes to existing tariffs and technology trade between the two countries. Adding fuel to the political tensions were the recent curbs on U.S.-to-China shipments of semiconductors used for artificial intelligence. “Tough on China” is now consensus U.S. policy.

Surprisingly, according to one study from the Peterson Institute for International Economics, tariffs had a relatively minor inflationary impact (just 0.26% of the 6.8% increase in the CPI between November 2020 and November 2021).

That said, we cannot deny that the two-decade period of disinflation has probably ended. Rising political tensions will most likely amplify inflationary pressures. This antagonistic relationship is aimed at thwarting China’s strategic aim to lead the next generation of technology through applications in semiconductors, artificial intelligence (AI), environmentally friendly industry and agriculture.

U.S. policymakers view this as a threat, especially given the possibility that advanced technology could end up in the hands of a Chinese military working against U.S. interests. Echoing that concern was a study from the Center for Security and Emerging Technology, which found almost all the 97 AI chips in public Chinese military purchase records from April to November 2020 were designed by U.S. firms (NVIDIA, Intel, Microsemi, Xilinx and Advanced Micro Devices).

The U.S. still ranks number one in advanced chip technology. However, because China holds sway over supply chains and the bulk of high-end production facilities, maintaining that leadership role is problematic. To shore up its position, the U.S. is encouraging the private sector, through the recently passed CHIPs Act, to expand domestic manufacturing and reduce reliance on remote supply chains that were clogged during COVID lockdowns in China.

Dismantling twenty years of technology partnerships will have longer-term implications and unintended consequences. Because technology is ingrained in so many aspects of everyday living, it is the cutting edge of a sword that will slice through globalization like a hot knife through butter, eventually degrading free-trade efficiencies and increasing cost pressures.

Also worth highlighting is the risk to the global commodity complex from greater U.S.-China tensions. Efforts to “green” the world’s energy supply highlights the concentration risk embedded in supply chains for battery inputs. China controls more than 50% of the world’s refining and processing of lithium while the U.S. has just 1% of the market share. Global conflicts could impact these key commodities and increase costs.

To highlight the immediate risk, consider the 814% increase from December 31, 2020 to October 2022  in lithium prices, the key ingredient for batteries that power electric cars. Tesla has applied for a permit to build its own U.S. based facility to develop battery-grade lithium hydroxide, while also lobbying the U.S. private sector to increase domestic investment. Expansion of supply capacity would help reduce longer-term inflationary pressures, but such transitions add to short-term capital expenditures at a time when supply chains remain vulnerable to near-term disruption.

The elephant in the room is Taiwan. Two issues come to mind: 1) the role that Taiwan plays in the production of high-end semi-conductors; and 2) the amount of trade that flows through the Taiwan Strait.

Both the U.S. and China are reliant on Taiwan Semiconductor, which fabricates more than half of the world’s semiconductors. It manufactures 70% of China’s chips and 92% of the most advanced chips designed by the U.S. This makes Taiwan something analogous to a child caught in the middle of a vicious custody battle. According to The Stimson Center, a research firm specializing in geopolitics, an attack on Taiwan would make “the supply-chain impact of the COVID-19 pandemic seem like a mere hiccup in comparison.”

The impact goes beyond the production of chips. The Taiwan Strait and South China Sea are home to high-traffic maritime trade routes. A blockade of the Taiwan Strait would be less permanent than a full-blown invasion but would create bottlenecks as more than 19% of global trade and just under 6% of Japan and U.S. maritime trade passes through the adjacent South China Sea. A conflict is not imminent, but with Xi Jinping as President for life, the situation could change rapidly and warrants close attention.

Advancing Domestic Consumption as Demographics Shift

In May 2021 China began its 14th Five-Year Plan which articulated a strategic shift to reshape the Chinese economy. The CCP wants to elevate the middle class (and living standards more broadly) by transitioning from a manufacturing to a services-led economy.

The goal is to increase domestic production while retaining external competitiveness through exports. To accomplish the transition to a more stable growth trajectory, China must increase productivity while bolstering consumption.

In the long term, China’s demographics may be the biggest challenge in terms of its inflationary impact and growth prospects. While aging demographics is a global phenomenon, nowhere is it more acute than in China. A demographic tsunami is about to hit China as its population ages at the fastest rate of any major economy.

Between 2000 and 2015, China’s labour force grew by 8%, the equivalent of 61 million people. It took the U.S. 40 years to grow its labour force by that same amount. However, it is estimated that China’s population may have peaked in 2022, which is dramatically sooner than the United Nation’s 2019 projection that China’s population would peak between 2031 and 2032.

Attempts at a course correction from China’s long-standing one-child policy have failed to raise China’s fertility rate, and 2.5 years of COVID restrictions have exacerbated the “baby bust.” China’s old-age dependency ratio (65+) is projected to increase from about 20% today to 50% or so by 2050. During that time, the working-age population (15–64) is expected to shrink by approximately 25% while the population 65+ will roughly double.

The link between demographics and inflation is critical in two ways. According to the secular stagnation thesis, an aging population can result in higher savings and investment, lower spending, and therefore lower inflation. At the same time, a recent Bank for International Settlements paper shows a positive correlation between the dependency ratio (the ratio of elderly or dependents divided by the working-age population) and inflation. The researchers found that demographics reduced inflation by approximately 3% between 1970 and 2010 and projected that from 2010 to 2050 aging demographics will lift inflation by about 3% on average across countries on a cumulative basis.

For global inflation over the next decade, the key question is whether another country or region can step into China’s shoes as a global supplier of inexpensive labour. We are doubtful. The CCPs command-and-control economy combined with foreign direct investment allowed it to invest aggressively in infrastructure to support the global manufacturing economy. We see no countries waiting in the wings that could present a substitute to China’s combination of inexpensive labour, infrastructure and manufacturing  expertise.

China’s demographic challenges are colliding with a strategic pivot in economic and geopolitical policy. As its economy ages and moves into higher-paying, service-oriented jobs, we anticipate China’s influence on global prices to switch from disinflationary to inflationary. When combined with global tensions and an increased corporate interest in diversifying supply-chain risk, we expect inflation to be structurally higher than it has been during the heyday of globalization.

Richard Croft, Chairman & CIO

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