News & Analysis

The outlook for the Canadian economy is bleak, as per the Bank of Canada’s latest Q3 surveys. The Business Outlook Survey summary indicator fell to -3.51, the lowest reading since the pandemic and the weakest ever recorded outside of a recession, while the Canadian Survey of Consumer Expectations suggest that the Canadian consumer is set to tighten its belt further.

Furthermore, expectations of future sales continued to decline on softer domestic demand, with public sector spending and exports expected to partially offset the domestic consumer spending slowdown. Given this context, firms have reduced both their investment and hiring intentions to their lowest levels since 2020. In addition, nearly half of firms (46.7%) said that the effects of higher interest rates have just begun, while another third (31.6%) said they have only seen about half of the total impact they anticipate. If this were the whole story, the Bank of Canada could feel confident about leaving its policy rate unchanged at 5.0%, allowing the lagged effects of monetary policy to complete the job of restoring inflation to 2%. But there are two major sticking points. Inflation and wage expectations, while converging back towards longer-term averages, remain quite elevated.

Firms think that inflation will run at an annual pace of 3.3% over the next two years, which is a poor vote of confidence in the central bank’s ability to normalise inflation over the near term, while many firms believe it may take as long as three years to return inflation back to target.

Additionally, wages are expected to rise by 4.3% over the next year, which is inconsistent with the inflation target unless Canada sees a sudden improvement in productivity, an unlikely outcome. In summary, while the results of today’s Q3 surveys generally tilt dovish, concerns within the inflation and wage measures mean the Bank of Canada can’t rule out further interest rate hikes just yet. We now look towards September’s inflation report tomorrow for signs on whether the latest uptick in core inflation momentum was temporary or sustained to determine whether the BoC hikes or holds at next Wednesday’s meeting.

Business outlook suggests economic growth will remain weak 

Over the past two decades, the share of businesses who expect sales growth to deteriorate has only ever exceeded the share expecting improvements on two occasions, during the 2008-09 and Covid-19 recessions. According to the latest data, the proportions of optimistic and pessimistic businesses are exactly the same at 37%, with the gap between the two steadily closing since the second quarter of 2021. With the balance of opinion sitting at zero, significantly below its historical average of +26%, the sales outlook suggests that Canada’s economy is teetering on the edge of a recession, and the risks will only grow as the lagged impact of past interest rate hikes continues to build.

The vast majority of firms say that higher interest rates are negatively impacting them, and while the impact has grown more widespread across sectors, the most notable change was seen in services industries.

Specifically, 73% of firms in the services sector now say that they are feeling the impact of higher rates, up from 53% in Q2. In the goods sector, meanwhile, the share increased from 66% to 76% over the same period. This is particularly important considering the services industry is Canada’s engine of growth, with services GDP growth of 2.0% over the past 12 months counterbalancing the -1.4% contraction in goods. With fewer firms expecting to make investments or expand their workforce over the next year, continued economic stagnation now appears to be the best case scenario for the Canadian economy, with a mild recession being our base case.

The key to Canada’s economic outlook will be the labour market.

While hiring intentions have fallen, most firms do not expect to make layoffs. While not contained in the Business Outlook Survey, there have been several reports from firms saying they are afraid of laying off workers because of the difficulty in finding and training new workers once business conditions improve. It is for this reason that we do not expect a severe recession in Canada. But the downside risk is that firms will no longer be able to withstand softer demand and are forced to cut costs by reducing their headcounts, which would virtually guarantee a more substantive downturn.

Although inflation could remain above target for several years

Despite rising interest rates and slowing demand growth creating a weak outlook for sales, the BOS and CSCE still have bad news on the inflation front. Not only are most businesses planning for inflation to run above 3% over the next two years, but they also expect their own price increases to be larger and more frequent than normal. Consumers, meanwhile, are expecting inflation to run above 4% over the next two years, with expectations ticking up from 3.93% to 4.04% from the previous quarter and interrupting the downward trend.

High inflation could remain supported by high wage growth, which firms say largely reflect a catch-up effect as workers demand compensation for the rise in prices since the pandemic.

Against a backdrop where core inflation momentum has proven persistent and even increased in August, this will make for difficult reading for BoC policymakers even as the growth and hiring outlook is becoming more consistent with a narrowing output gap.

The labour market is seen as healthy, producing higher-than-average wage growth

A consistent theme across both the BoS and CSCE was the perceived strength in the labour market, even as capacity constraints continue to ease. Within the BoS, the balance of labour shortages remained around historical averages, while the level of intensity cooled further from -23 to -46, well below the historical average of 11. As a result, firms reported a gradual easing of expected wage inflation, but still cited that wage growth is expected to remain above historical averages due to skill shortages in some industries, minimum wage legislation, and the rate of inflation.

Within the CSCE, consumers also reported a relatively muted risk of losing their job within the next twelve months, while the probability of voluntarily leaving in the next twelve months and finding a new job in the upcoming quarter remained elevated.

Not only does this suggest confidence in hiring conditions, which is consistent with recent net employment gains and positive net employment intentions by firms, but may also point to continued churn within the labour market as workers seek to buffer the reduction in their purchasing power. This was visible in both firm and consumer wage growth expectations, which remained high even though they were converging back to historical averages. The average reported wage increase across firms was 4.3%, down just 18 basis points from Q2, while consumer expectations of real wage growth remained negative over the upcoming twelve months, but improved from -2.52% to -2.31%.

All told, the labour market dynamics won’t read as overly concerning for policymakers at the BoC, especially as elevated levels of immigration are easing wage pressures and thus the passthrough to underlying inflation pressures.

Furthermore, neither businesses nor consumers are expecting a substantial easing in labour market conditions, which given the backdrop of slowing demand, would be consistent with a recessionary outlook.

 

 

Authors: 

Jay Zhao-Murray, FX Market Analyst

Simon Harvey, Head of FX Analysis

 

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