Canada’s economic outlook: The dawn of recovery

The Canadian economy will turn a corner toward recovery in the second half of the year, setting the stage for a true revival next year.

Although Canada has managed to avoid a recession, the lack of growth has been discouraging as elevated interest rates have taken their toll.

The good news is that rate cuts will soon fuel a recovery. As interest rates drop, the cost of servicing debt will go down, encouraging consumer spending and business investment.

Inflation is on track to drop to 2.5 per cent this year and return to the Bank of Canada’s target of 2 per cent next year.

Immigration remains Canada’s not-so-secret weapon as population growth translates to consumer demand and the expansion of the labour supply. At the same time, caps on temporary residents—including international students and temporary workers—will limit population growth and keep the unemployment rate and rent increases tapered.

The public sector will continue to be a driver of job growth, especially in health care.

Housing costs continue to be a sore point for consumers. Households and businesses remain resilient and still manage to make debt payments despite high interest rates. But higher debt-servicing costs mean households must cut discretionary spending and businesses must hold back investments; this, in turn, hampers growth.

The main risks to the outlook include the reignition of inflation because of a possible depreciation of the Canadian dollar (CAD) against the U.S. dollar (USD) and geopolitical uncertainties. Inflation, together with elevated wage growth, could delay further rate cuts and thus recovery.

Interest rate differential and exchange rate

The Bank of Canada and the U.S. Federal Reserve have moved somewhat in lockstep since the onset of the recent pandemic. They both dropped the policy rates to 0.25 per cent in March 2020, began raising rates two years later in March 2022 and have held the peak rates since July last year.

But the economic trajectories of Canada and the United States are diverging. While the Canadian economy has barely grown, the U.S. economy continues to expand despite high inflation and interest rates.

Because of the widening growth gap, the Bank of Canada has already started to cut its policy rate and will be more aggressive than the Federal Reserve.

The Bank of Canada kicked off the rate cut cycle with a quarter-point reduction in June; we forecast a total of four cuts to bring the overnight rate to 4 per cent by the end of the year. 

Meanwhile, the Fed will not begin lowering rates until September and might cut them only twice this year. The Bank of Canada will most likely reach a terminal rate of 3 per cent by the end of next year, while the Fed might take until early 2026.

This divergence in central bank policies could cause the CAD to lose value against the USD. The USD/CAD exchange rate, currently at 1.36, could inch closer to 1.4.

The interest rate differentials could cause investments to flow to the U.S. instead of Canada as investors seek higher returns.

Imports could get more expensive for Canadian consumers and businesses, potentially driving up inflation, which poses a threat for the Bank of Canada. The central bank may be forced to keep rates higher for longer.

Still, while we expect the impact to be visible, it will not be enough to counter the disinflationary factors in the global and Canadian economies.

Inflation

Disinflationary forces will continue, bringing inflation down gradually. The primary disinflationary factor is weak consumer demand as households cope with high interest rates by reducing discretionary spending.

While half of mortgage holders have renewed their mortgages, the other half are still to be hit with higher interest rates. This means the impact of restrictive monetary policy on consumer spending will continue to resonate in the upcoming months and years.

If shelter or mortgage interest payments are excluded, inflation is back on target. The consumer price index (CPI) excluding shelter has fallen below 2 per cent for three months, and the CPI excluding mortgage interest payments has been at 2 per cent for three months.

Housing remains a hot-button topic as housing inflation will continue to outpace the headline number.

But housing costs are seeing some relief. The condo market is softening after seeing much-needed supply as construction that began during the negative real rate era of 2021–22 reaches completion.

The limits on temporary workers and international students will also moderate housing demand as well as rent increases this fall. These are not long-term solutions, but rather short-term reliefs that will keep rent increases in check later this year.

Cooling labour demand means wage growth will likely ease toward the summer and fall, which will further add to the trend of easing inflation.

Labour market

Hiring could pick up slightly later this year as rate cuts make investments more palatable for businesses. The unemployment rate will top out at 6.4 per cent and will remain above 6 per cent for the remainder of the year and into next year.

April’s job report, which shows the economy added quadruple the jobs expected, is a testament to Canada’s resilience. Nevertheless, the undeniable trend over the past year is a slowdown in hiring, despite many part-time or public sector jobs added in recent months.

The public sector, including health care, education and public administration, has been an exception as public investments result in hiring.

Over the past year, public sector employment went up by 208,000, while private sector employment only rose by 190,000. The public sector will continue driving employment through the end of the year, though the trend might slow as governments contend with higher interest payments.

Population growth will continue to add to the labour supply. While the target for new permanent residents this year and 2025 is 500,000 per year, many of them are already inside the country.

In the past two years, the population increase largely came from incoming temporary residents: international students and temporary workers.

Recent limits mean that the labour supply will not expand by as much, keeping the unemployment rate relatively low, even at peak, compared to that in previous rate hike cycles.

Household sector and business investments

High housing costs continue to strain consumer demand. Renters are particularly affected, but mortgage holders also face higher interest payments.

While consumer bankruptcies have only slightly increased and remained below pre-pandemic levels, the number of bankruptcy proposals has surged, surpassing pre-pandemic levels. This highlights increased financial vulnerability among households.

A silver lining is that falling inflation and steady wage growth are boosting real household incomes, which could increase aggregate spending despite high debt servicing costs.

The era of higher-for-longer means that businesses will find ways to innovate as rates will fall but stay above those of the past two decades.

The completion of major projects like the Trans Mountain pipeline will reduce energy infrastructure investments, but new initiatives in manufacturing and transportation, particularly in the electric vehicle sector, are likely to boost investments in the second half of the year.

Trade with the U.S. could slow as the U.S. economy might cool later this year.

Businesses might shift the focus from maintenance to expansion next year, which will kick the economy into new gear.

The takeaway

The second half of the year marks the beginning of Canada's economic recovery, with more robust growth anticipated next year. The divergence in central bank policies between Canada and the United States will also play a crucial role in shaping the economic landscape.

While challenges remain, particularly high housing costs, the expected rate cuts and continued population growth provide a foundation for renewed prosperity.