Canada’s economy: navigating through rate cuts, inflation, and uncertainty

Inflation hits the target, but challenges remain

The announcement that inflation has returned to two percent in August was met with optimism in Ottawa. Finance Minister Chrystia Freeland referred to it as a “light at the end of the tunnel” for Canadians struggling with rising costs and economic disruptions. This achievement followed a period where wage growth outpaced inflation for 19 consecutive months, reflecting a shift toward stabilizing prices after a turbulent period of price increases during the COVID-19 pandemic.

However, Nathan Janzen, while acknowledging the importance of this inflation target, warns that the positive news masks deeper problems. According to Janzen, inflation subsiding is not just a result of effective monetary policy, but also an indication of a weakening economy. For seven of the last eight quarters, Canada’s economic output has shrunk on a per capita basis, exacerbated by weak growth and a rapidly increasing population. This growing labor force has contributed to the unemployment rate reaching 6.6 percent, a seven-year high outside the pandemic era.

Why the economy is stalling despite rate cuts

To understand why Canada’s economy is stalling, it is essential to revisit how inflation control works. When inflation moves away from the Bank of Canada's two percent target, the central bank increases its policy rate, raising the cost of borrowing for consumers and businesses. This results in slower economic activity as both households and companies cut back on spending, allowing supply to catch up with reduced demand.

Canada’s rapid inflationary pressures necessitated the most aggressive rate-tightening cycle in the central bank’s history. While inflation is now under control, the economy is feeling the effects of these earlier rate hikes. Janzen notes that interest rates, though lower now after three cuts, remain in “restrictive” territory. They continue to suppress economic growth rather than stimulate it, making recovery slow and fragile.

Moreover, interest rate changes take time to fully affect the economy, often between 12 to 18 months. This means that while inflation has improved, the drag of higher rates will continue to impact economic activity for some time. Freeland herself acknowledged earlier in the week that high interest rates have been acting as a “brake” on the economy and while this pressure is easing, it is not yet neutralized.

The looming threat of mortgage renewals

One significant challenge on the horizon for many Canadians is the upcoming wave of mortgage renewals. Nearly one-fifth of Canadian homeowners are set to renew their mortgages within the next year, most of them at significantly higher rates than when they first took out their loans. Many of these mortgages were secured at much lower interest rates during the early years of the pandemic.

James Orlando, director of economics at TD Bank, notes that unless the Bank of Canada aggressively cuts rates beyond what is currently anticipated, Canadians will face a substantial increase in their mortgage payments. This could further suppress consumer spending, dragging the economy into a prolonged period of slow growth. Orlando predicts that without faster rate cuts, it may take until mid-2025 before economic growth begins to pick up again.

Janzen echoes this concern, pointing out that higher mortgage payments will continue to weigh on household budgets. This could delay the economic recovery as Canadians will be hesitant to draw down their savings and increase spending, which are key factors in driving economic growth.

How low can interest rates go?

As the Bank of Canada continues to cut rates, economists are debating how far and how fast the central bank will go. Orlando estimates that the current policy rate is around 175 basis points higher than necessary to spur growth. If the Bank of Canada continues its current pace of 25-basis-point cuts per meeting, it could be mid-2025 before significant growth reappears. However, the speed and depth of future rate cuts will depend on how the economy responds.

The central bank remains cautious. Despite inflation reaching the two percent target, Bank of Canada senior deputy governor Carolyn Rogers emphasized that one favorable inflation report does not mean the problem is fully solved. At a business event following the release of the August inflation report, Rogers reiterated that while reaching two percent is encouraging, the central bank seeks sustained price stability over time.

The possibility of a "soft landing," where inflation is controlled without tipping the economy into recession, remains uncertain. Janzen warns that the unemployment rate, which is nearing a two-percentage-point increase from its cycle lows, poses a significant risk. While widespread layoffs have been avoided thus far, particular groups like young people and newcomers are facing increasing difficulties in securing employment, raising concerns about broader economic fragility.

The road ahead – is 2025 the turning point?

Looking ahead, economists like Janzen and Orlando suggest that 2025 could be the year when Canada's economy begins to recover more robustly. While there is still uncertainty regarding how much the Bank of Canada will cut rates and when, there is growing confidence that the economy will see brighter days ahead. However, until consumer and business confidence returns, the economy may continue to "drag along," as Orlando puts it, with slow growth in the meantime.

For Canadians, this means that while inflation may be under control, the economic challenges are far from over. Higher mortgage rates, elevated interest rates, and ongoing unemployment issues will continue to weigh on households. Janzen notes that the current trajectory suggests we are closer to the end of this period of economic pain, but there is still some distance to cover before the economy fully recovers.

source: Global News