REAL ECONOMY BLOG | August 08, 2023

The Canadian economy has shown remarkable resilience this year, defying expectations of a downturn amid elevated inflation and rising interest rates.

In our updated economic forecast, we have downgraded the probability of a recession in Canada over the next 12 months to 60%, from 75%.

A 40% probability of a soft landing is nontrivial thanks to strong labour demand, healthy consumer spending and a housing market that is still robust. These factors are in part fueled by Canada’s ambitious immigration policy as well as healthy household savings from the pandemic.

Inflation has declined to 2.8%, the lowest among G7 countries. The decline is an encouraging sign that a rate peak is in sight for the Bank of Canada.

While the Canadian economy will muddle through the rest of the year with slower growth, our view is that Canada will avoid a recession this year.

In our forecast, the economy will expand by 0.4% in the third quarter and remain steady in the last quarter, with a slowdown continuing into the first half of next year.

The housing market is on solid ground after a brief lull at the beginning of the year as demand continues to outpace supply, leading to high rental and purchase prices despite high interest rates.

That said, this strength could be derailed if a major exogenous shock were to occur, sending food and fuel prices upward and pushing the economy into a recession.

Bank of Canada to hold rates steady

Falling inflation, coupled with signs of cooling labour demand, might be enough for the Bank of Canada to hold its policy rate at 5%, although one more hike is possible if emerging data tells a different story.

One can breathe a sigh of relief with headline inflation now below 3%. The decline has occurred much faster than anticipated thanks to lower energy prices.

Core inflation measures, despite trending downward, have remained sticky because of the high prices of services. In addition, businesses still plan on raising prices at a faster pace than before the pandemic.

Data on gross domestic product and jobs could send mixed signals in the second half of the year as the economy absorbs a series of temporary shocks such as strikes and forest fires.

The Bank of Canada will be closely monitoring core inflation, labour demand and consumer spending as it tries to walk the fine line of restoring price stability while not over-tightening.
Regardless, the Bank of Canada’s first rate cut will not come before the second quarter of next year.

One reason is that the central bank is keen on taming inflation expectations among consumers and businesses alike. Officials will want to see inflation remain low for an extended period before slashing rates.

On the flipside, sustained higher rates translate to higher borrowing costs for businesses, which hurt business investments, especially in high-risk sectors such as technology.

Immigration fuels economic growth

Immigration has played a pivotal role in helping Canada avoid a recession by not only adding to the labour supply but also boosting consumer demand.

Without immigration, Canada would have a declining population and a shrinking workforce. Instead, Canada now has the highest population growth since 1957 and one of the highest growth rates among the developed economies.

To be sure, immigration has drawbacks, such as straining the already-tight housing supply in cities and adding to price pressures. Still, immigration will help the economy overall into next year.

Labour market moderates

Labour demand remains strong but is showing early signs of moderating. The economy added 290,000 jobs in the first six months of the year, though most of the growth was concentrated in the first quarter.

While job vacancies remain elevated above pre-pandemic levels, they have decreased to the lowest level since May 2021. That decline is indicative of a cooling labour market and is a trend we expect to continue through the year’s end.

As an indicator of resilient labour demand, real wages have been growing but could stagnate into next year as the economy slows.

We expect the unemployment rate to creep up to 5.6% by the year’s end, which is still below the pre-pandemic average of 5.7%.

Looking at the big picture, businesses are often concerned with the long-term economic outlook beyond the next month or the next quarter. To this end, labour productivity has flattened and even decreased in recent years.

Canada risks falling behind its peers in the global economy, and short-term fixes would not be enough. Instead, an economy and policies that encourage innovation, more openness and less protectionism would ensure long-term prosperity.

Household spending to taper

Consumer spending has been surprisingly resilient, keeping the economy buoyant. But a closer look reveals that consumer spending is being financed by a drawing down of savings.

Savings from the pandemic have given households a buffer, but this will most likely wind down amid the dual challenges of inflationary pressures and rising interest rates.

At the same time, Canadian households’ debt levels have ballooned, standing at 180% of income. According to the Bank of Canada, over a third of mortgage borrowers have seen their interest payments rise, with more to come as more mortgage terms expire.

When households pay more for housing, they have less money to spend on goods and services.

This means monetary policies are working as intended: to cool consumer demand and the economy. Whether or not they can cool the economy without pushing it into recessionary territory remains to be seen.

The takeaway

The data through the end of the year will paint a mixed picture for the Canadian economy with alternating months of GDP growth and contraction, and of job gains and losses. But one thing is clear: the Canadian economy will slow down.

At the same time, solid consumer demand, a robust labour market and strong housing sector are all tailwinds for the economy. Those tailwinds have pushed the probability of a soft landing to 40%, which, if achieved, would be no small feat for the Bank of Canada.

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