With restrictive financial conditions, high interest rates and still-elevated inflation, the Canadian economy has come to a standstill and is now at a tipping point.
The Bank of Canada’s decisions over the next few months could influence whether the economy arrives at a soft landing or falls into a recession.
The Bank of Canada’s decisions over the next few months could influence whether the economy arrives at a soft landing or falls into a recession.
The central bank is tasked with the challenge of achieving price stability while the economy weakens. Cutting rates too early could risk reigniting inflation. Conversely, waiting too long risks an unnecessarily long and deep economic downturn.
Many indicators suggest that the Bank of Canada might start its rate cuts in June, with a 25 basis-point reduction. But that risks a delay that could needlessly tip the economy into recession.
In our view, the central bank should start in April. We also expect a minimum of four 25 basis-point cuts this year to bring the rate down to 4 per cent.
The Bank of Canada has been clear that it will not begin cutting rates until it has enough evidence that inflation is under control. Now, that evidence is mounting. The economic slowdown both at home and abroad indicates that it will soon be time for the central bank to take its foot off the brakes.
Two years ago, Bank of Canada led the G-7 in one of the fastest rate hike cycles in history. Now, it is time for the Bank of Canada to lead, this time in rate cuts.
The last mile to price stability
It took a year for inflation to fall from 8 per cent to 3 per cent, yet for the past six months inflation has barely budged, illustrating the difficulty in getting inflation down to the central bank’s target of 2 per cent.
But disinflationary forces are growing. Monetary policy stomped out excess demand and has tipped the economy into excess supply. Higher rates mean higher mortgage payments, which prompts households to cut spending. As consumer demand wanes, businesses will not be able to keep raising prices.
Read more of RSM Canada’s insights on the economy and the middle market.
The job market is slowly tilting into an employers’ market, which could soon dampen wage growth.
Core inflation will most likely continue to decline, albeit slowly, as previous rate hikes are felt throughout the economy.
A global economic slowdown will keep prices of goods, including gasoline and energy, in check, and lead to disinflation in the spring and summer.
The biggest challenge in taming inflation remains housing. Excluding shelter, inflation had already fallen to 2.4 per cent by December. Excluding mortgage interest payments, this figure is 2.5 per cent.
Shelter inflation stems from two main factors: High rent growth because of the housing shortage and increasing mortgage interest payments because of higher interest rates.
The Bank of Canada cannot fix the former. The chronic housing shortage will take years to address, from all levels of governments and from businesses.
Monetary policy is directly contributing to the latter. When homeowners renew their mortgages, their payments increase because of higher rates.
Even after the Bank of Canada begins cutting interest rates, monetary policy will remain restrictive and the policy rate will far exceed the average of the past 20 years. Since it takes 18 to 24 months for the full impact of rate changes to take hold, last year’s rate hikes will continue to dissipate inflationary pressures across the economy.
Cutting rates to aid recovery
While Canada most likely will not see 2 per cent inflation until next year, the central bank does not have to wait until then to drop the policy rate.
The macroeconomic environment in Canada is looking considerably weaker than in the United States. Businesses and consumers in Canada have higher debt levels than in the U.S. and are more rate sensitive.
The RSM Canada Financial Conditions Index, which measures risk priced into financial assets, remains negative because of increased levels of risk and volatility in the bond market and because of the decline in commodity prices.
The Bank of Canada’s Senior Loan Officer Survey confirms these excess risks because of tight lending conditions.
For the past few months, consumer spending per capita has been declining, the number of hours worked has dropped and the unemployment rate has been creeping up.
In December, Canada lost 23,500 full-time positions while adding 23,600 part-time jobs. While the overall jobs number increased, the truth is that labour demand has decreased.
Households have pulled back spending to afford their higher mortgage payments. Businesses are delaying hiring and investments.
The real interest rate already stands at 2 per cent and will rise as the nominal policy rate stays constant and inflation eases.
It will take time for investments and spending to recover, but a rate cut in early spring might give the economy the extra push it needs to get over the hump and revive in the second half of this year.
Risks remain
Inflationary risks have not gone away. Shelter inflation will most likely be a pain point not only now but in the upcoming years as housing supply fails to keep up with demand.
Wage growth is still in the 4 per cent to 5 per cent range, which means that prices of services will take time to decelerate. But cooling labour demand means that lower wage growth might be on the horizon.
There is also risk in the exchange rate. The Bank of Canada and the Federal Reserve have largely synchronized their policies, and the Fed is expected to begin its first rate cut in June.
A cut by the Bank of Canada before the Federal Reserve could lead to the Canadian dollar losing value in the short term, making goods more expensive for Canadian businesses and consumers, which means increases in inflation.
But the impact will be temporary as another bump in the road. The Canadian dollar would gain some value by the end of the year, which would help ease inflation into the mid-2 per cent territory.
The takeaway
The Bank of Canada’s trajectory this year will be a gradual moderation of its policy rate, absent another major shock.
The first half of the year will be challenging for businesses and consumers with high interest rates and will bring muted growth. But an earlier start to the rate cuts could allow the economy to revive in the second half, as long as inflation stays under control.
