The year ahead: Weak growth, rate cuts and a return to price stability

PERSPECTIVE | December 12, 2023

Authored by RSM Canada

The Canadian economy showed remarkable resilience this past year, adding jobs and investment in the face of elevated inflation and rising rates. But gradually, the impact of these higher rates has taken hold, putting the brakes on business and consumer activity.

The coming year will be characterized by weaker growth as excess supplies put a drag on expansion. In our baseline, the economic outlook for the coming year will be split into two distinct phases: a shallow and short slowdown in the first half of the year followed by a revival in the second half. By 2025, the economy will be poised for more expansion.

The probability of a recession stands at 45 per cent in our view as the lack of growth persists through the first quarter. If a recession were to occur, it would be in the first quarter.

As inflation decreases and nominal interest rates stay steady, real interest rates rise, which increases the cost of borrowing and dampens the appetite for investments.

We see the Bank of Canada starting to cut rates in the second quarter, pushing the policy rate down toward 4 per cent by the end of next year.

We expect Canada’s real gross domestic product to rise by a quarterly 0.3 per cent in the first quarter before accelerating to 1.3 per cent in the second, 1.9 per cent in the third and 2.2 per cent in the fourth. On an annual basis, we expect GDP to grow by 0.7 per cent next year. 

Businesses are expected to delay investments until the second half of the year when financial conditions are more favourable, the cost of borrowing falls and inflation eases.

Household debts will be a drag on the economy, though, hindering spending as more than half of mortgages are set to renew at much higher rates. A big reason for the reset is the length of the average mortgage in Canada, which is five years compared to the standard 30-year term in the United States. Many Canadians, as a result, will soon face a significant increase in their monthly mortgage payment—a major expense—and will have to adjust their spending.

The federal government is looking at its spending as well, having announced plans to tighten budgets going into 2024 to avoid fueling inflation. Still, important sectors like health care, public infrastructure, technology and clean energy will see bolstered investments to meet increasing demand from population growth and to meet climate targets.

Immigration will continue to bolster the economy, adding to the labour supply and consumer demand. While there will be strains on housing, social services and infrastructure, immigration helps ease the worker shortage and benefits the economy in the long run.

Risks to the outlook

Several risks threaten to cloud the outlook. Restrictive monetary policy, the high cost of doing business and elevated household debts could induce an economic slowdown that is steeper and deeper than expected. Weak productivity will continue to be a challenge that prevents growth.

A delay in the global economic recovery, especially in China, could reduce demand for Canadian goods, particularly raw minerals and coal.

Another risk is geopolitical uncertainty. If the current conflict in the Middle East spreads, causing energy prices to increase and stay high, the Bank of Canada would have to keep rates elevated for longer. The Russia-Ukraine war could also strain global supplies of energy and food, creating shortages and pushing up prices.

Extreme weather events related to climate change like wildfires and floods could not only result in costly insurable events but also disrupt supply chains and food production, further pushing up prices and undermining growth.

Monetary policy

The impact of a tighter monetary policy, with the end of the era of near-zero interest rates, will be felt throughout the year. The business environment will improve once rate cuts begin in the second quarter, but it will be fundamentally different from the past 20 years.

While core inflation measures remain elevated, they are slowly trending in the right direction.

The Bank of Canada does not expect inflation to return to its 2 per cent target until late 2025. Our view is that the central bank will not try to get to 2 per cent at the cost of economic prosperity but will feel comfortable as long as inflation stays in the 2.5 per cent to 3 per cent range and inflation expectations remain anchored.

Restrictive financial conditions, coupled with the reduction of the Bank of Canada’s balance sheet, will continue. Business and personal borrowing will be limited until the second half of the year as rates ease.

Our proprietary RSM Canada Financial Conditions Index, which stands at 1.7 standard deviations below normal, has deteriorated amid increased volatility in government securities and wider corporate spreads and as commodity prices have dropped.

Equities are underperforming and the money market is showing signs of rising stress; we attribute that to the anticipation of rate cuts for government securities and to stickier prices for commercial lending.

We can expect these conditions to continue until the policy rate reaches its equilibrium level.

Toward the second half of 2024, the Canadian dollar should gain strength as the global pull toward the American dollar as a safe haven currency eases.

It’s worth emphasizing again that there is an important difference between Canada from the United States: the length of time that homebuyers can fix their mortgage rates. In Canada, it’s five years. In the U.S., it’s 30. While 90 per cent of American homeowners have mortgage rates under 5 per cent, nearly 40 per cent of Canadian homeowners have mortgages that exceed 5 per cent with the rest bracing for a rate reset. This leads to Canadians pulling back spending and increasing saving while Americans are spending down their savings and anticipating an economic expansion.

Inflation

Inflation will continue to decline toward 3 per cent, though the road will be bumpy. As demand slows, businesses will have less room to raise prices.

Given the significant changes affecting Canada’s economy in recent years, including an aging population, fragmented supply chains, geopolitical uncertainty and climate change, an inflation rate of 2.5 per cent to 3 per cent will become the new normal.

The most stubborn piece of the inflation puzzle is the shortage of homes that has pushed up the cost of housing—a challenge that will persist into 2024 and beyond. Rent prices have also seen double-digit year-over-year increases as demand outstrips supply.

Labour market

Slower economic activity will bring fewer hirings in early 2024, though widespread layoffs are not expected. Though the economy will add jobs in most months, the unemployment rate will stay around 6 per cent until the second quarter, an elevated figure though still low by historical standards.

The momentum on wage growth, which exceeds 5 per cent and is well above inflation, is likely to wane as labour demand cools.

Even in a more balanced job market, though, workers will continue to demand better working conditions, more flexible working arrangements and better job security against the threat of automation.

Immigration will continue to fuel the workforce. In 2024, Canada aims to welcome 485,000 new permanent residents plus hundreds of thousands of international students and temporary workers. Canada’s immigration policy can be flexible to attract the immigrants needed to fill gaps in the labour force.

One sore point, however, is the licensing of professionals like doctors. Barriers continue to prevent foreign-trained professionals from practicing in Canada, leading to underemployment and a drag on productivity.

Another win for the workforce, in addition to immigration, is the government’s new 50 per cent discount in daycare fees, which is moving daycare toward a $10 daily cost by 2025. This will add hundreds of thousands of parents, mainly women, to the workforce, as demonstrated by Quebec when the policy was enacted there decades ago.

Industrials

The industrials sector will have to contend with excess supply, the limited ability to pass on costs given lower demand and pressures to embrace automation to cope with the worker shortage.

The trend of bringing production back home can direct valuable investment dollars to Canada, especially as the U.S., Canada’s largest trade partner, is on track to skirt a recession altogether and move straight into economic expansion.

Public and private investments in clean energy have led to the construction of electric-vehicle plants and heightened demand for raw minerals like lithium. Additional opportunities to be part of the semiconductor boom are there as well.

The upskilling and reskilling of workers will be essential to ensure that automation complements, and does not replace, workers.

With carbon prices set to go up in the coming year, companies will need to embrace technology to increase efficiency, engage in the energy transition and reduce emissions to maintain margins.

Real estate and construction

There is no way around it: the housing shortage will continue in the coming year. The solution requires drastically increasing the supply of homes, but it’s not happening fast enough.

With record immigration comes mounting demand for housing, but Canada is unable to meet that demand after years of structural undersupply.

The result is a housing crisis with severe shortages and unaffordability throughout the country, not only in major cities. Rental vacancy rates are at the lowest level in two decades as new immigrants and temporary residents look for a place to live and buyers are increasingly priced out of the market.

The current low rate of building permits and housing starts will stay muted through the first half of the year; consequently, the shortage will worsen in 2025 and 2026.

The second half of 2024 will have more construction activity as lower interest rates spur building and more favourable zoning laws allow for higher density. But the new construction will still be eclipsed by demand.

The resale market will stay active through the middle of the year as investors look to offload properties that are no longer sound investments under higher mortgage rates.

Household sector

Record household debt and a higher cost of living, particularly with housing costs, will cloud consumer spending in 2024.

The rise in household debt is primarily because of increases in uninsured mortgages—or mortgages where homeowners have paid more than 20 per cent of the price of the house—and non-mortgage and credit card loans. The most concerning trend is credit card loans, which have steadily increased over the past year, because they have high interest rates that can exceed 20 per cent.

Another concern is the rise in negative amortization, where homeowners with variable rate mortgages find that their fixed payments no longer cover interests and their principal balance climbs. As a result, households will rein in spending and beef up saving through the first half of 2024.

Consumers with high mortgage payments and credit card loans are more vulnerable to negative shocks. But while delinquency is on the rise among non-mortgage holders, increasing foreclosures are not in the picture since households prioritize paying mortgages above all other expenses.

Consumers will delay the purchase of goods that require financing, like cars and appliances, until mid-to-late 2024, after interest rates have begun to drop.

The post-pandemic shift in spending away from goods toward services and experiences is here to stay. But consumers might have to be content with taking fewer trips and seeing fewer concerts in 2024 given the higher cost of living, higher debts and easing wage growth.

In aggregate, consumer spending will still go up thanks to immigration, but real consumption per capita will remain flat until late 2024.

The takeaway

After restrictive monetary policy slows down the economy and inflation approaches 3 per cent, the growth outlook will turn brighter toward the end of 2024. Once interest rates begin to ease, likely in the second quarter, the conditions allowing for more business borrowing and growth will improve.

Immigration will be a crucial driver for the economy. Canada will also benefit from the trend of nearshoring and onshoring and investments in clean energy, as well as its abundant natural resources. But the high cost of living, elevated household debt, geopolitical uncertainly and climate change threaten to undermine the outlook.