Canada’s economy outperforms in first quarter, raising pressure on Bank of Canada ahead of next week’s rate decision

However, this economic resilience poses a challenge for the Bank of Canada, which is intentionally seeking to slow down the economy in order to control inflation. Governor Tiff Macklem and his team paused their campaign of raising interest rates in January but have indicated that they may resume rate hikes if economic growth and inflation do not decelerate as expected.

If the central bank decides to implement another rate hike, it could occur as early as the upcoming monetary policy decision next Wednesday. This move would raise the benchmark rate to 4.75 percent, leading to increased borrowing costs and further escalating mortgage servicing expenses. Market indicators, such as interest-rate swaps, currently suggest a nearly 40 percent probability of a quarter percentage point rate increase next week, with approximately a 60 percent likelihood of a rate hike by July.

“The run of sturdy data undoubtedly raises the odds that the Bank of Canada needs to go back to the well of rate hikes, and even puts some chance on a move as early as next week’s policy decision, however, given the uncertain backdrop and the possibility that inflation took a big step down in May, the BoC could opt to remain patient for a bit longer and signal that it’s open to hiking in July if the strength persists.” Bank of Montreal chief economist Douglas Porter wrote in a note to clients.

In April, the inflation rate stood at 4.4 percent, slightly higher than March but significantly lower than the peak of 8.1 percent observed last summer, which was the highest in four decades. Central bankers anticipate a decrease in inflation to around 3 percent by this summer, although it may take longer to reach the Bank of Canada’s target of 2 percent.

During the first quarter, Canadian households played a pivotal role in driving economic growth. Consumer spending increased by 5.7 percent on an annualized basis, following two-quarters of minimal growth. Both goods and services experienced growth, with notable increases in spending on cars, clothing, food, and travel services.

Exports saw a substantial increase of 10.1 percent on an annualized basis, primarily driven by sales of passenger vehicles, metals, and agricultural products across the border.

However, certain sectors of the economy displayed signs of weakness. Housing investment, encompassing new construction, renovations, and ownership transfer costs, declined for the fourth consecutive quarter due to higher interest rates suppressing real estate activity. Moreover, businesses reduced their investment in machinery and equipment for the third consecutive quarter and scaled back on inventory accumulation.

The growth observed in the first quarter was front-loaded. GDP experienced a 0.7 percent month-to-month growth in January, followed by a slowdown to 0.1 percent in February and stagnation in March. According to Statscan’s preliminary estimate for April, there was a 0.2 percent month-to-month growth in GDP, which exceeded analysts’ predictions but was far from the rapid pace seen in January.

Most economic forecasters, including those at the central bank and financial institutions on Bay Street, anticipate a virtual halt in economic growth for the remainder of 2023, with some predicting a mild recession later in the year. It typically takes 18 to 24 months for interest rate changes to have a full impact on the economy, and the Bank of Canada initiated rate hikes only 15 months ago.

So far, some of the impacts of higher borrowing costs has been blunted by banks letting their customers extend the amortization period on variable-rate mortgages rather than forcing them to pay more each month. But over time, a growing portion of Canadians will need to renew their mortgages at higher rates, leaving them less money for discretionary spending.

“I do expect that we’re going to see these very big interest-rate hikes bite on the consumer side, but it’s a matter of timing, the labour market hasn’t shown any significant signs of fraying. But that doesn’t mean it won’t. Because when you look at business surveys, we’re seeing businesses are a little bit nervous. They’re happy supply chains are better, but of course we have higher costs to finance,” Ms. Desjardins said. Dawn Desjardins, chief economist at Deloitte Canada, said in an interview. The key question in the short and medium term is what happens to employment.

She said that employers appear keen to keep their workers, given how difficult it’s been to find qualified employees. But the pace of hiring will likely ease in the coming months, pushing up the unemployment rate and curbing overall consumer spending.

Household disposable income fell 1 percent in the first quarter, compared with the previous quarter, the first reduction since the fourth quarter of 2021. Employee compensation rose at a brisk quarterly pace of 1.7 percent, but a decrease in government transfers offset this.

A growing number of economists think the Canadian economy can achieve a “soft landing” – where inflation falls back to the Bank of Canada’s 2-per-cent target without a major economic contraction or a sharp rise in unemployment.

But on this front, the resilience of the economy is a double-edged sword: It’s good for businesses and workers, but it could mean inflation takes longer to fall and it increases the odds of additional rate hikes, implying more pain for mortgage holders.

“In our baseline forecast, the labour market will soften as the economy slows. Wage growth will ease. Businesses will revert to more normal price-setting behaviour. And near-term inflation expectations will come into line with the inflation target, but there is a risk that these adjustments will take longer or stall, and inflation will get stuck materially above the 2-per-cent target.” Mr. Macklem said in a speech last month.

Source: https://www.theglobeandmail.com/business/article-canada-gdp-first-quarter-2023/