Shoppers walk past a boarded up storefront on Saint-Catherine Street in downtown Montreal, Dec. 19, 2023.Christinne Muschi/The Canadian Press
Craig Alexander has served as chief economist at Deloitte Canada, the Conference Board of Canada and Toronto-Dominion Bank.
The Canadian economy is struggling with high interest rates and a housing affordability crisis. Yet the message from the Bank of Canada is one of tough love. The central bank is not willing to lower interest rates until the war against inflation is decisively won. This has far-reaching implications.
The most immediate implication is that the Canadian economy will remain weak this year. While it does look like a soft landing is being achieved, with a recession avoided, the bad news is that the economy is likely to stagnate and there will be pockets of domestic weakness that will add to some of Canada’s leading economic challenges.
The latest economic data drives home this point. While the economy managed to post meagre growth of 1.0 per cent at an annualized rate in the fourth quarter of 2023, the slim gain was largely the product of strong export growth that speaks to the relative economic strength of the U.S. economy. In contrast, Canadian consumer spending on a per-person basis fell and domestic demand contracted by 0.7 per cent annualized in the final quarter of last year.
High interest rates and their impact on demand are deterring business investment in machinery and equipment, which contracted at a 5.7 per cent annualized rate in the fourth quarter, the fifth drop in six quarters. This is disheartening because Canada needs more investment in capital per worker to boost productivity. In 2023, labour productivity fell by 1.8 per cent, marking a third consecutive annual decline. This is a problem because productivity is the primary source of a rising standard of living. Before the COVID-19 pandemic, labour productivity growth was responsible for 90 per cent of the rise in income per capita.
Elevated borrowing costs are also adding to Canada’s housing affordability crisis. The Bank of Canada is worried about cutting interest rates because it fears that lower rates will reignite Canadian residential real estate markets, which could push up shelter costs and make it more difficult to return inflation to 2 per cent. While this is a distinct possibility, it should also be acknowledged that high mortgage rates are reducing the pool of homebuyers, keeping more individuals in rental markets that are overheating. Rents rose 7.9 per cent year-over-year in January.
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High interest rates are also making it more expensive for rental property owners to finance their buildings – mortgage interest costs were up 27.4 per cent year-over-year in January – and this too is adding to rent increases. Higher capital costs for builders, reflecting elevated interest rates, has also weighed down residential construction, which fell 10.2 per cent in 2023, at a time when inadequate supply of homes is contributing to the affordability crisis.
The combination of weak demand and high borrowing costs is also causing businesses financial strains. Business insolvencies have soared in recent months, surging 48.8 per cent in January, reaching a 17-year high and 163 per cent above prepandemic levels.
These are examples of the economic costs being incurred to lower inflation and they are trends that are likely to persist in the near term. Eventually, the economic weakness will sufficiently dampen inflation to motivate the central bank to begin cutting interest rates.
Financial markets are betting that the central bank will ease policy in June or July, but some commentators are warning that we might not see interest rate relief until the fall. It should be stressed, however, that the future pace of monetary policy easing is likely to be gradual. If so, it will take many months, and likely well into 2025, for interest rates to drop to a level that no longer applies brakes to the economy.
Make no mistake, the Bank of Canada will win the war against inflation, and this is a good thing. High inflation deeply erodes the standard of living of Canadians. Inflation is also highly regressive, hurting low-income Canadians the most. The brutal inflation shock we have just lived through demonstrates why price stability is so important.
But returning us to low and stable inflation is creating its own set of economic scars, and it is adding to some of Canada’s structural economic challenges of weak business investment, poor productivity and housing affordability problems.
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