Inflation is back at the coveted two per cent annual rate.
Wage hikes have outpaced inflation for 19 months in a row.
The Bank of Canada is three rate cuts into an easing cycle, with no signs of stopping anytime soon.
The recent run of positive economic news had the Liberal government — long challenged by an affordability crisis in Canada — celebrating in the House of Commons this week.
Finance Minister Chrystia Freeland on Tuesday hailed the August inflation report as “good news for Canadians” and the “light at the end of the tunnel” after years of surging prices and pandemic-related disruptions in the economy.
RBC assistant chief economist Nathan Janzen tells Global News that there’s indeed reason to celebrate as price stability shows signs of returning and the Bank of Canada unwinds from the most rapid tightening cycle in its history.
But he also warns that focusing on inflation and rate cuts may ignore economic pain looming for Canadians around the corner.
“Light at the end of the tunnel, silver lining, whatever the phrase you want to use is, it’s important to remember that what we’re seeing in terms of inflation and the interest rate cuts is a result of a softening Canadian economy,” Janzen says.
“So it’s not all great news.”
Why is the economy still stalling?
Quick refresher on how all of these dynamics play together: when inflation is trending away from the Bank of Canada’s two per cent target, the central bank will raise its policy rate in an effort to rein in rampant price growth.
Higher interest rates raise the cost of borrowing for Canadians, businesses and governments. That discourages big purchases and encourages saving, which slows down the economy and gives supply time to build up while demand dwindles.
From all accounts, that’s been happening. Consumer spending and business investment have slowed, and Canada’s economic output is largely below trend.
Janzen notes that for seven of the last eight quarters, Canada’s economy has shrunk on a per-person basis, the reflection of both weak overall growth and a surging population.
That rapid growth in the size of Canada’s labour force has also driven the unemployment rate up to 6.6 per cent — a seven-year high outside of the pandemic — despite relatively few job losses as the economy slows.
But here’s the thing about the Bank of Canada’s policy rate: Even after three quarter-point cuts, it’s still in what economists and the central bank would consider “restrictive” territory, meaning it’s suppressing the economy.
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“Interest rates are still higher than they were. They’re still at levels that even the Bank of Canada would view as acting as a headwind to the economy, rather than a tailwind,” Janzen explains.
Changes in interest rates can take between a year to 18 months to be fully absorbed into the economy. In other words, those dampening impacts that helped to tame inflation are likely to persist even as rate cuts continue to materialize.
Freeland herself acknowledged the persistent pressures earlier in the week, before the latest inflation news dropped.
“High interest rates have been working as they were intended to do, they have been a brake on the Canadian economy,” she told reporters Monday. “The pressure on that brake is easing, but we’re not at the neutral rate of interest yet. So the brake is still in place.”
Mortgage renewals remain a looming threat
The “neutral rate” of interest is the point at which the Bank of Canada’s policy rate is neither stymying or stimulating economic growth. By the end of the rate cut cycle, most economists expect the policy rate will end up somewhere below neutral to give the flagging economy a bit of a boost.
How low the Bank of Canada goes, and how quickly it gets there, is what’s up for debate. James Orlando, director of economics at TD Bank, says that he believes the policy rate is 175 basis points above where it needs to be to spur growth.
“If at the current pace of 25-basis-point cuts per meeting, it’s going to be into mid-2025 before we even start to see economic growth start to accelerate,” he told Global News in a recent interview.
Orlando expects the economy will “drag along” with middling growth until shy consumers and businesses regain their confidence to get spending again.
Over the next year, roughly a fifth of homeowners are set to renew their mortgages — the vast majority adjusting into higher rates than what they took out either before or in the early years of the COVID-19 pandemic.
“Unless the economy gets substantially worse and central banks cut aggressively more than are expected, then those mortgages are still going to be renewing at significantly higher interest rates over the next couple of years,” Janzen says.
He says that’s the major hump for the Canadian economy to get past before households feel confident drawing down their savings and spending again.
How fast can rates come down?
Economists have become increasingly confident in the Bank of Canada’s downward trajectory for rates, but that path is far from certain. The central bank laid out scenarios in its deliberations from the last rate decision this week that could see it slow the pace of cuts if the economy proves resilient, or cut by larger amounts if risks for a steeper economic slowdown materialize.
News of two per cent inflation in August had some forecasters and market watchers raising their bets for an accelerated 50-basis-point rate drop at the central bank’s next meeting in October, a move some economists say was made more likely by the U.S. Federal Reserve’s half-point cut earlier this week.
This all leads to some important questions: if inflation is back at the Bank of Canada’s two per cent target and the economy is stalling, why put Canadians through the pain of higher rates? Why not drop rates immediately to the neutral rate or lower?
In part, that’s because the central bank’s own officials aren’t ready to declare victory.
Speaking at a business event on Tuesday after the August inflation report, Bank of Canada senior deputy governor Carolyn Rogers acknowledged that it was “good news” after a “long journey.”
But she also said the Bank of Canada isn’t looking to just hit two per cent in a single report, it wants to see that price stability is, well, just that: stable.
“We’re glad to see two per cent, but no, there’s still work to do,” she said.
“We’ve got to stick the landing.”
Janzen says the idea of a “true soft landing,” where the Bank of Canada successfully reins in inflation without tipping the economy into a recession, might be at risk with the unemployment rate verging on a nearly two-percentage-point rise from its cycle lows.
While there have not been widespread layoffs to this point, he notes that weakness has been heavily concentrated in youth and newcomers, both of whom are having a particularly difficult time landing their first jobs in Canada.
With persistent headwinds facing the economy, Janzen expects the unemployment rate will “gradually drift higher” in the months ahead.
Like Orlando, Janzen expects that the declines in interest rates mean Canadians are in store for brighter days in 2025. He cautions that while there may well be a light at the end of the tunnel, Canada’s economy has a ways to go before it’s feeling the sunshine.
“It’s not like we’re expecting a significant change in economic conditions, but things will start to look a little better into next year,” Janzen says.
“We do expect that we’re … significantly closer to the end than we are in the beginning.”
