Canadian economy unlikely to dodge a downturn despite early-2023 resilience

Economic growth has been more resilient than feared in the wake of aggressive interest rate increases last year and the expected upcoming recession still sits firmly on the ‘mild’ side of historical downturns, according to a new report released Wednesday by RBC Economics.

“But we don’t expect a bumpy landing for the economy to be avoided altogether. Certainly, there is a chance that broader near-term consumer spending could be stronger and less sensitive to interest rate increases than expected. Labour markets have been very strong, and households accumulated a large amount of savings over the pandemic. But with the supply of goods and services already unable to keep up with demand, stronger spending would result in stickier inflation pressures—and higher interest rates. These rates will cut further into household purchasing power down the road, delaying but not preventing a downturn,” said the report.

“Recent inflation data has been encouraging, particularly in Canada, and the easing in price growth is diluting some of the larger downside risks to the macroeconomic outlook. But in reality, consumer demand probably needs to soften for inflation to return fully to central bank target rates. And the alternative to the relatively mild ‘bumpy,’ economic downturn we expect in 2023 could still look more like a crash landing down the road if substantially higher interest rates, and a larger pullback in economic activity, is required to get inflation fully back under control.”

The report said labour markets have been resilient so far, but it takes time for higher interest rates to hit consumers’ and businesses’ debt payments.

“A large share of household borrowing in Canada comes from fixed rate mortgages with payments that don’t reset until contracts are renewed,” it said.

“The share of household disposable income eaten up by debt payments was still below pre-pandemic levels at the end of last year, but will rise to record levels by the second half of this year. That will be compounded by a sharp pullback in household net wealth as housing markets continue to retrench. With households feeling less wealthy and higher debt payments and prices cutting into purchasing power, consumer spending is likely to slow later in 2023.

“We continue to expect unemployment rates to drift higher – to 6.8 per cent in Canada from 5.0 per cent currently by early 2024.”

It said an immigration-fueled surge in population growth in the wake of pandemic lockdowns will help fill some current gaps in labour markets and will add almost a million consumers to the Canadian population over 2023 and 2024. That boost the production (and consumption) potential of the economy and will help put a floor under economic growth with GDP growth to resume positive, but modest, growth after mid-year declines. Still, we don’t expect those initial increases to be large enough to push unemployment significantly lower in 2024 with central banks cautious about reverting from interest rate hikes to cuts too quickly.