The Canadian Economy… What is next?

Bryan Brulotte - Unity. Prosperity. Compassion. #CanadaUnited

With the country’s inflation rate holding below 3%, the Bank of Canada lowered its key interest rate earlier this month by 25 basis points. Most observers saw this as a sign the bank’s post-pandemic fight against inflation is drawing to a close. However, how will interest rates evolve over the coming months?

Interest rates are falling – The economy is slowing

Canadian households and businesses are no doubt feeling relief. High interest rates have been a source of frustration and concern for many. After nearly a year at 5.0%, the balance between supply and demand seems to have returned.

While this month’s interest rate cut should be seen as good news, the shift in monetary policy is a sign the economy is slowing down.  Indeed, it implies that the high rates introduced to curb inflation by encouraging households and businesses to restrict their spending can now be gradually phased out because the economy has rebalanced sufficiently.

While economic activity is not declining across the country, the pace of growth has weakened. Real GDP growth in 2023 was 1.1%, while the Canadian economy’s growth potential is an estimated 2.0%. The trend of slow but positive growth continued in the first quarter of 2024 and should persist in coming months. It’s what’s famously known as a soft landing.

When it comes to inflation, the situation is beginning to return to normal following the price surge caused by the pandemic. Since the start of 2024, inflation as measured by the Consumer Price Index has remained within the Bank of Canada’s target range of 1-3%. Some consumer categories are still experiencing price increases well above what we expected to see in a more balanced economy, notably housing.

Future reductions are expected…

As far as interest rates are concerned, we consider the situation to be “normal” when the key rate is between 2.25% and 3.25%.  Although the Bank of Canada has given no indication of how quickly it will cut, I believe rates could fall by a further 50 to 75 basis points by the end of the year. The economy will therefore continue to be confronted with restrictive interest rate levels, meaning ones that discourage indebtedness.  Unless there is a major, unpredictable shock, the key interest rate should fall gradually, until the neutral rate is reached.  Ultimately, I expect the Bank of Canada to bring the policy rate back close to 2.75% (the mid-point of the neutral rate range), but this won’t happen until 2026.

The Bank of Canada will be cautious

Many companies will be helped by lower borrowing costs, even if the reductions remain modest for the time being. Therefore, this month’s first cut is a cause for optimism and should help restore confidence among consumers and businesses alike. We can expect it to help the economy regain some strength. The Bank of Canada will be cautious in its forthcoming decisions for fear that demand will pick up too quickly, resulting in a rebound in inflation. The bank is also faced with structural (i.e., longer-term) issues that it must take into account in its decisions. The housing crisis, government policies regarding fossil fuels, and an ageing population will continue to exert pressure on certain prices. These trends will impact businesses costs as well.