Resilience Comes at a Cost: Scotiabank’s Forecast Tables

• Economic resilience to higher interest rates is keeping inflation uncomfortably high.

• A slowdown is still expected though a strong start to the year means the moderation is likely to be delayed to the second half of this year.

• Risks to inflation remain tilted to the upside and require continued vigilance by central banks. One more rate increase is expected in Canada and the US, and we are delaying the expected cut in policy rates to the second quarter of 2024.

The resilience of the Canadian and US economies to dramatic interest rate increases of the last year has been nothing short of remarkable. Repeated forecasts of an imminent slowdown on the part of the economics profession and policymakers have yet to materialize in any meaningful ways. While this may very well be interpreted as good news by some, it is not good news for firms and households that must contend with the higher interest rates that result from stubbornly strong economic activity and therefore inflation. It is now evident that slightly higher policy rates are needed in Canada and the US to achieve the slowdown required to ensure inflation slows to 2% over the next couple of years. The Bank of Canada made this clear in its most recent decision to raise its policy rate by 25 basis points and leaving the door open for more hikes to come. The Fed, which opted to keep rates unchanged at its latest meeting, indicated that they believed at least another 50 basis points of tightening was required this year to achieve their objectives. Clearly, policymakers believe a bit more must be done. We agree with them.

We remain of the view that the policy tightening in this cycle will lead to a modest decline in economic activity in Canada even though the economy is off to a strong start this year. We expect growth to slow from about 1.3% this year to 0.6% next year with a small contraction in economic activity in the second half of this year. Household spending remains remarkably resilient to efforts to slow it, as witnessed by an increase in real consumption per capita in the first quarter of the year. A further driver has been the historic strength in population growth, which has acted as a powerful tailwind for the economy even as the Bank of Canada has been trying to create a formidable headwind with higher interest rates. Higher population growth should increase the economy’s potential to grow in a non-inflationary way, but the short-run demand impacts of new arrivals are undeniable. Population estimates from the Labour Force Survey reveal that the population of 15-year-olds and above has risen at the most rapid pace in history so far this year, with that pace gathering steam in May (chart 1). This strong population growth is likely putting some downward pressure on wages as it makes it easier for firms to source workers, but it is also likely contributing to the decline in productivity growth. 

On the labour front, markets remain remarkably tight. Labour markets lag the cycle so we should not be expecting a correction ahead of a slowdown, but there should be some indications of softening by now. The May employment report showed a small decline in employment though that was bizarrely concentrated in younger workers. Survey measures show labour market tightness remains acute. The Canadian Federation of Independent Business’ monthly Business Barometer suggests that the proportion of firms expecting to shed workers in the next 3 to 4 months stands at the lowest level since June 2022. Labour shortages continue to be the most critical obstacle to firm performance according to this same survey. Nevertheless, we expect broader job cuts as the impact of higher policy rates works its way across the economy. Those cuts, however, are likely to be tame by historical standards given the still large number of vacancies. We forecast a modest increase in the unemployment rate from the current 5.2% to 5.6% by year-end and 6.2% by end-2024. This is in sharp contrast to previous cyclical corrections, where the unemployment rate has risen by several percentage points.

Developments on the housing front should be an ongoing concern for the Bank of Canada. The Spring market remains very strong suggesting a lift from housing market activity on the economy as opposed to the impact it has been having since policy rates started to rise. Governor Macklem can ill afford that given the considerable efforts the BoC has deployed to slow the economy. The most recent increase in the policy rate will have some impact on activity in this space but there are limits to what can be achieved by monetary policy in the housing market given the very sharp structural imbalance between the supply and demand for housing.

The stronger start to the year and weak productivity growth continue to suggest that upside risks to inflation should dominate policy concerns. Core inflation should come in just under 4% this year and remain above 2% throughout the next year. This suggests that risks to the rate profile are tilted to the upside as well. As a consequence, we believe Governor Macklem and his colleagues will raise interest rates one final time in the third quarter before calling it quits. We also now believe that the first rate cut will occur in the second quarter of next year as opposed to our previous view of a cut but in the first months of 2024. A similar dynamic is likely to play out in the United States, with the Fed very clearly signalling that it is not yet done raising interest rates. We believe another 25 basis points of tightening will be required there, with evident risks of additional rate increases. It seems inconceivable to us at this time that either central bank will cut rates this year.