Canada’s economy unexpectedly contracts in second quarter, setting up next week’s BoC rate decision

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People can be observed shopping at Toronto's Eaton Centre in this archived image.

The Canadian economy started to struggle when faced with the burden of increased borrowing expenses during the second quarter, which strengthens the argument for the Bank of Canada to maintain interest rates at their current level next week.

According to Statistics Canada, the economy experienced a decline in economic activity during the quarter, with a rate of 0.2 percent when calculated on an annualized basis. This fall can be attributed to a decrease in new construction projects, a slowdown in consumer spending, and the impact of wildfires on resource industries. On a positive note, a preliminary estimate for the month of July suggests that the gross domestic product remained relatively stable, indicating a lack of significant growth as we enter the latter half of the year.

"Rate increases are a thing of the past": The unexpected GDP figures of today have altered the perspectives of economists and markets.

The Gross Domestic Product (GDP) figures did not meet the expectations set by the Bank of Canada and Bay Street, which had projected 1.5 percent and 1.2 percent annualized growth, respectively. This indicates that the impact of increased interest rates on the economy might be greater than initially understood. As a result, it is more likely that the Bank of Canada will decide to maintain its benchmark rate at five percent during the upcoming Wednesday.

"In his communication to customers, Stephen Brown, deputy chief economist for North America at Capital Economics, expressed the concern that the Canadian economy may have already entered a slight recession due to the decline in monthly GDP in June and the apparent lack of progress in July, which does not bode well for the third quarter."

Some of the slowdown is due to unique circumstances. Many sectors, such as mining, rail transportation, oil and gas extraction, and the accommodation industry (specifically RV parks and campgrounds), were impacted by wildfires in June. Additionally, in April, a strike by federal government employees affected economic activity in the public sector.

Nevertheless, there were numerous indications of a broader decrease in activity during the second quarter following a successful start to the year. The decline was primarily driven by a 2.1% decrease in housing investment, comprising an 8.2% decrease in new construction and a 4.3% decrease in renovations. According to Statistics Canada, these drops coincided with the Bank of Canada's decision to resume its tightening of monetary policy in June, following a five-month break.

Expenditure by individuals within their households also decelerated during the quarter, experiencing a modest growth of merely 0.1% in contrast to the 1.2% growth recorded in the previous quarter. Consumers hesitated when it came to purchasing new automobiles, furniture, and outdoor recreational equipment. However, this decline was counterbalanced by an increase in spending on newly released trucks, vans, and SUVs, as the automotive supply chains have shown signs of improvement.

According to Statscan, although total household expenses slightly increased during the second quarter, individual spending per person decreased by 0.7%. In fact, per capita household spending has declined in three out of the last four quarters.

The Bank of Canada has been facing challenges in managing the desires of households, as it is making efforts to control the expenditure of consumers on various products and services in order to moderate the rate of inflation. In June, when the bank resumed increasing interest rates, officials highlighted the unexpectedly high level of consumer demand as a major factor behind their decision.

Recent statistics, combined with underwhelming retail figures, indicate that certain Canadian consumers are starting to exhaust their spending capacities.

Additional factors that hindered economic growth during the second quarter included a deceleration in the buildup of business inventories, which expanded at the least rapid rate since the final quarter of 2021. Furthermore, trade had a negative impact on GDP, as imports surpassed exports.

Bond yields decreased following the report, with the two-year interest rate on Government of Canada bonds falling approximately 10 basis points to 4.55 on Friday afternoon. (A basis point is equivalent to 0.01%). In the past few weeks, bond yields have pulled back due to uninspiring data releases in the United States, which have diminished the likelihood of the U.S. Federal Reserve implementing another interest rate increase in September.

The most recent information from Statscan on Friday is the final significant economic release before the Bank of Canada determines its interest rates on September 6th. Previous data has mostly indicated a slowdown in the economy. This was evident in the July employment report, where approximately 6,400 jobs were lost and the unemployment rate increased to 5.5 percent in Canada.

On the other hand, the issue of inflation is showing resistance. The yearly increase in the Consumer Price Index escalated to 3.3 percent in July, compared to 2.8 percent in June. However, the core indicators of inflation, which exclude unpredictable price fluctuations, experienced a minor decline.

"In light of the 0.5% increase in the unemployment rate, the significant deceleration in GDP, and a slight decrease in core inflation, it appears that the era of raising interest rates has come to an end," stated Doug Porter, the top economist at Bank of Montreal, in a message to their clientele.

Currently, the Bank of Canada is required to exercise patience while awaiting the arrival of inflation. However, this process might be time-consuming, particularly due to the resurgence of oil prices.

The main goal of the central bank is to reduce inflation by moderating the economy without going too far and triggering a difficult recession. In their most recent economic prediction, released in July, they anticipate a moderate yet optimistic GDP growth rate of approximately 1 percent from the latter half of this year until the first half of the following year.