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Governor of the Bank of Canada, Tiff Macklem, walks outside the Bank of Canada building in Ottawa.BLAIR GABLE/Reuters

As the Bank of Canada nears the end of its historic interest rate-hike cycle, much of the impact of higher borrowing costs has yet to be felt in the economy.

The housing market has been in a slump since the spring. But other aspects of the Canadian economy, including employment and consumer spending, have been resilient in the face of seven consecutive rate hikes. Inflation remains stubbornly high.

Economists expect this to change in the coming quarters. Monetary policy tightening works with a lag, squeezing discretionary spending as homeowners renew their mortgages at higher rates, and hitting different industries with varying force and speed.

Even if the Bank of Canada stops raising interest rates in its next decision in January – a possibility, according to central bank officials – the rate-hike campaign of 2022 could reverberate for months and years to come.

“We know this is a very challenging time for Canadians. Increased borrowing costs in the near term will deliver the benefits of low inflation, but only with a delay,” central bank deputy governor Sharon Kozicki said in a speech last week, after the bank’s latest 50-basis-point rate increase, which took the benchmark lending rate to 4.25 per cent.

This delayed reaction guarantees more pain ahead for many Canadian households and businesses, which face the challenging blend of slowing growth and high inflation, often called stagflation. The central bank is forecasting near-zero GDP growth through the first half of 2023, putting the economy on the edge of recession, and it expects unemployment to rise.

Bank of Canada delivers a subtle but clear signal rate-hike cycle is nearing its end

How this plays out will ultimately depend on the way higher interest rates percolate through different industries, and how tight monetary policy interacts with a peculiar mix of high debt levels, abundant savings and a tight labour market.

“This is uncharted territory,” said Craig Alexander, chief economist at Deloitte Canada. “Given the uncertainty of how highly leveraged households will respond to higher interest rates, it makes the risk of over tightening more likely. Which could then necessitate a prompt reversal.”

It typically takes six to eight quarters for rate increases to have a full impact on inflation. This happens in phases: first squeezing rate-sensitive sectors such as real estate, then curbing consumer spending as mortgage costs rise, and finally hitting employment and business investment. Weaker demand for goods and services, in turn, forces companies to stop raising prices and eventually start offering discounts, which slows inflation.

So far, the main casualty has been the housing market. The number of home sales across the country was down 39 per cent in November, compared to the previous year, while the national average sale price was down around 12 per cent, according to the Canadian Real Estate Association.

“It took less than a quarter to see the impact on prices and overall sales activity,” said Karen Yolevski, chief operating officer of Royal LePage Real Estate Services.

The sharp drop in sales stems from both market uncertainty and a decline in affordability, Ms. Yolevski said in an interview. Many potential buyers and sellers are waiting to see where prices settle before jumping back into the market. Others have been priced out, as rising mortgage costs have yet to be balanced out by a sufficient drop in home prices.

The auto industry is also being pinched as lease rates and financing costs rise. Shahin Alizadeh, chief executive of Downtown AutoGroup, a group of car dealerships in Toronto, said this is mostly happening in the high-end of the used-car market.

There is still a huge demand for new vehicles as a result of the backlog in manufacturing over the past two years, Mr. Alizadeh said in an interview. And there are more cash buyers who are less sensitive to interest rates, given the extra savings built up during the pandemic. Still, he said he’s right-sizing his vehicle inventory in anticipation of a further drop in demand.

“Can we predict what happens in the next 180 days? I can’t. But one thing we are doing is sort of buckling down and making sure we’re not going to get blown away.”

Overall consumer spending in Canada has been remarkably resilient to the sharp rise in interest rates.

Canadian Tire chief executive Greg Hicks noted on an earnings call last month that shoppers are dialling back purchases of non-essential items such as electronics and furniture, but upping their spending on things like auto parts, plumbing and pet food. Canadian Tire’s retail sales in the third quarter were down from the preceding quarter but still $700-million above 2019 levels, he said.

Nonetheless, cracks are starting to form. Canadian household spending was down 0.3 per cent in the third quarter from the previous one, the first drop since the second quarter of 2021. Economists expect this decline to continue as a growing number of homeowners see their monthly mortgage costs rise, leaving them with less money for non-essential shopping.

“Households renewing an existing mortgage are facing a larger increase than has been experienced during any tightening cycle over the past 30 years,” the central bank noted in its October Monetary Policy Report. Many homeowners with variable-rate mortgages are already being squeezed.

Central bank researchers estimate that around half of all variable-rate mortgages with a fixed payment have already hit their so-called trigger rate, which means the mortgage holder has to up their monthly payments or shift some of the interest costs to the principal they owe. The bank expects this proportion to rise to about 65 per cent in the coming months.

Economists at Royal Bank of Canada estimate that the average household will have around $3,000 less in purchasing power next year, after accounting for inflation and higher debt costs. RBC is forecasting a “mild” recession next year as consumers spend less.

Many economists argue that Canada is particularly sensitive to rising interest rates because of high levels of household debt, and the importance of the housing market to the overall economy.

Indeed, we’re already seeing some divergence between the Bank of Canada and the U.S. Federal Reserve in terms of the expected end point of each central bank’s tightening campaign. After raising the federal funds rate by another 50 basis points on Wednesday, Fed officials signalled they expect the rate to top 5 per cent by the end of 2023. The Bank of Canada, by contrast, has said it could stop raising rates as early as next month.

“Canadians are already devoting much more of their income to debt service than their American friends across the border,” Canadian Imperial Bank of Commerce chief economist Avery Shenfeld said in an e-mail.

“That gap will widen in 2023, as Canadians renew more mortgages, while Americans generally remain locked into fixed rate mortgages that run for as long as 30 years. That’s a good reason for the Bank of Canada to pause at a lower rate than the Fed.”

What does this mean for getting prices under control? Inflation has been trending down since the summer. But the annual rate of consumer price inflation still stood at 6.9 per cent in October, more than three times the Bank of Canada’s 2-per-cent target. The central bank expects this to fall to around 3 per cent by the end of 2023, and return to 2 per cent by the end of 2024.

Former Bank of Canada governor Steven Poloz said inflation could decelerate faster than many people expect. Oil prices and shipping costs have come down significantly. And interest rates are likely “more powerful” today than in previous tightening cycles because of higher household debt and the extensive use of variable-rate mortgages in recent years, Mr. Poloz said in an interview.

Moreover, high inflation can be its own remedy, he said. With households dedicating more of their budgets to food, rent and gasoline, they have less to spend on non-essentials. This situation can spur companies to cut prices and squeeze their profit margins in an effort to keep people shopping, he said, pointing to Walmart as an example.

“They’re likely looking for every possible way to crunch their supply chain and get prices back down so people can fill their shopping carts up again,” Mr. Poloz said.

“That’s how disinflation happens. It doesn’t happen through the central bank magic wand. It happens when the pressure shows up in the actual marketplace and people can’t sell what they’re trying to sell.”

Bank of Canada Governor Tiff Macklem said at a news conference on Monday that it is “plausible” that interest rates will work faster than in the past. “That is something we are certainly looking at and taking into account,” he said.

There are other legs to the monetary policy tightening process. Business investment tends to decline as the economy slows. Likewise, home construction falls with a lag after a slowdown in sales.

Most of the houses and condo towers under construction today were financed two or three years ago, when interest rates were lower. Presales of homes dropped sharply over the past year, but this won’t show up in lower housing starts for a year or two, said Scott McLellan, COO of real estate developer Plaza Corp.

He said some projects have been paused, particularly purpose-built rental buildings. But he does not expect a significant slowdown in the construction industry because demand for tradespeople and building materials greatly exceeds supply. “There’s too much in the pipeline,” he said.

Mr. McLellan’s observation ties to a crucial question: What will happen to Canadian jobs in the coming quarters?

The Bank of Canada has said that unemployment needs to rise to slow down wage growth, which is feeding into high inflation. But the bank expects there will be a relatively mild increase in joblessness compared to previous recessions, thanks in part to an elevated level of job vacancies across the economy, which could act as a cushion for falling labour demand.

A recent central bank research paper suggested a “base case” scenario in which the unemployment rate rises to 6.7 per cent from 5.1 per cent today.

How long will this all take to play out? In a recent note to clients, Bank of Montreal chief economist Doug Porter pointed to the 1994-to-1995 tightening cycle as a potential analogue.

The Bank of Canada raised its policy rate by 4.5 percentage points over a year. The Canadian economy ticked along well as interest rates marched higher. But growth slowed abruptly in the second quarter of 1995, roughly a year after the rate-hike cycle began, and grew just 0.7 per cent over a four-quarter period.

“History tells us that weakness can arrive quickly when the rate hikes truly begin to bind,” Mr. Porter said.

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