Canada's economy outperforms in first quarter, raising pressure on BoC ahead of next week's rate decision – The Globe and Mail

The Canadian economy grew at an annualized rate of 3.1 per cent in the first quarter, outperforming expectations while adding pressure on the Bank of Canada to raise interest rates again, perhaps as early as next week.

After stalling in the fourth quarter of 2022, economic growth rebounded in the opening months of this year, buoyed by strong exports and robust consumer spending. That momentum appears to have continued into April, with a preliminary estimate from Statistics Canada showing stronger-than-expected growth that month despite the economic impact of the federal government workers’ strike.

Bay Street analysts had expected annualized first-quarter growth of 2.5 per cent, while the central bank had pencilled in 2.3-per-cent growth.

‘The stars are aligned’ for a further BoC rate hike: How economists and markets are reacting to today’s surprisingly strong GDP data

The GDP numbers, published by Statscan on Wednesday, are the latest upside surprise for the Canadian economy. Despite eight consecutive interest-rate increases in 2022 and early 2023, consumers have continued to spend, while businesses have continued to hire workers, keeping the unemployment rate near a record low.

This economic resilience is a problem for the Bank of Canada, which is deliberately trying to slow down the economy to bring inflation back under control. Governor Tiff Macklem and his team paused their rate-hike campaign in January, but have said they could raise rates again if economic growth and inflation don’t slow as quickly as expected.

Another rate hike, which could come as early as the monetary-policy decision next Wednesday, would increase the benchmark rate to 4.75 per cent, upping the cost of borrowing money and further pushing up the cost of servicing a mortgage. Interest-rate swaps, which capture market expectations about upcoming rate decisions, see a nearly 40-per-cent chance the central bank will raise rates by a quarter percentage point next week, and a roughly 60-per-cent chance they’ll raise rates by July.

“The run of sturdy data undoubtedly raises the odds that the Bank of Canada needs to go back to the well of rate hikes, and even puts some chance on a move as early as next week’s policy decision,” Bank of Montreal chief economist Douglas Porter wrote in a note to clients.

“However, given the uncertain backdrop and the possibility that inflation took a big step down in May, the BoC could opt to remain patient for a bit longer and signal that it’s open to hiking in July if the strength persists.”

The annual rate of inflation was 4.4 per cent in April, up a notch from March but well below the four-decade high of 8.1 per cent reached last summer. Central bankers expect inflation to fall to around 3 per cent by this summer, although it could take much longer to get back to the Bank of Canada’s 2-per-cent target.

Canadian households were the engine of economic growth in the first quarter, with consumer spending rising 5.7 per cent on an annualized basis after two quarters of minimal growth. This was up for both goods and services, with notable increases in spending on cars, clothing, food and travel services.

Exports increased 10.1 per cent on an annualized basis, led by cross-border sales of passenger vehicles, metals and agricultural products.

Other parts of the economy, however, showed signs of weakness. Housing investment, which includes new construction, renovations and ownership transfer costs, fell for the fourth consecutive quarter as higher interest rates continued to dampen real estate activity. Meanwhile, businesses cut their investment in machinery and equipment for the third consecutive quarter and pulled back on inventory accumulation.

Much of the first-quarter growth was also front-end loaded. GDP grew 0.7 per cent in January, month to month, before slowing to 0.1 per cent in February and flatlining in March. Statscan’s preliminary estimate for April shows 0.2-per-cent month-to-month GDP growth – stronger than analysts were predicting, but hardly the blistering pace seen in January.

Most economic forecasters, at the central bank and on Bay Street, expect the economy to essentially stall throughout the remainder of 2023, with some predicting a mild recession later this year. Interest rates typically take 18 to 24 months to have a full effect on the economy, and the Bank of Canada only began raising rates 15 months ago.

So far, some of the impact of higher borrowing costs has been blunted by banks letting their customers extend the amortization period on variable-rate mortgages rather than forcing them to pay more each month. But over time, a growing portion of Canadians will need to renew their mortgages at higher rates, leaving them less money for discretionary spending.

“I do expect that we’re going to see these very big interest-rate hikes bite on the consumer side, but it’s a matter of timing,” Dawn Desjardins, chief economist at Deloitte Canada, said in an interview. The key question in the short and medium term is what happens to employment.

“The labour market hasn’t shown any significant signs of fraying. But that doesn’t mean it won’t. Because when you look at business surveys, we’re seeing businesses are a little bit nervous. They’re happy supply chains are better, but of course we have higher costs to finance,” Ms. Desjardins said.

She said that employers appear keen to keep their workers, given how difficult it’s been finding qualified employees. But the pace of hiring will likely ease in the coming months, pushing up the unemployment rate and curbing overall consumer spending.

Household disposable income fell 1 per cent in the first quarter, compared with the previous quarter, the first reduction since the fourth quarter of 2021. Employee compensation rose at a brisk quarterly pace of 1.7 per cent, but this was offset by a decrease in government transfers.

A growing number of economists think the Canadian economy can achieve a “soft landing” – where inflation falls back to the Bank of Canada’s 2-per-cent target without a major economic contraction or a sharp rise in unemployment.

But on this front, the resilience of the economy is a double-edged sword: It’s good for businesses and workers, but it could mean inflation takes longer to fall and it increases the odds of additional rate hikes, implying more pain for mortgage holders.

“In our baseline forecast, the labour market will soften as the economy slows. Wage growth will ease. Businesses will revert to more normal price-setting behaviour. And near-term inflation expectations will come into line with the inflation target,” Mr. Macklem said in a speech last month.

“But there is a risk that these adjustments will take longer or stall, and inflation will get stuck materially above the 2-per-cent target.”

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