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Higher interest rates are supposed to rein in consumer spending, but households aren’t cutting back the way central bankers wanted

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When the Bank of Canada restarted monetary policy tightening in June, it placed the blame for more interest rate hikes squarely on consumers.

Rapid-fire rate increases last year were supposed to have squeezed household budgets and forced people to cut back on spending. By early summer, however, it looked like many Canadian shoppers had missed the memo.

Spending blew past expectations in the first quarter, aided by unseasonably warm weather in January. Through the spring, Canadians continued to splurge on travel, entertainment and restaurants.

“More unexpected was the strength of the rebound in goods spending, particularly the demand for interest-rate-sensitive goods, like furniture and appliances,” Paul Beaudry, one of the bank’s deputy governors, said after the June announcement, justifying the resumption of rate hikes after a five-month pause.

The resilience of the Canadian consumer has surprised economists and confounded central bankers. Fuelled by pent-up demand for in-person services as the COVID-19 pandemic has faded, and bolstered by high immigration and a strong labour market, consumer spending has remained remarkably sturdy through the first half of this year, despite rising prices and the most aggressive interest-rate hiking cycle in decades.

Inflation is changing the way Canadians are spending

It’s not just a Canadian story. Many central banks are contending with shoppers who refuse to wilt in the face of higher interest rates, challenging long-held assumptions about the transmission of monetary policy into the real economy. That includes the U.S. Federal Reserve, which raised its benchmark interest rate again this week to a 22-year high.

What happens next to interest rates, inflation and the broader economy will depend to a large degree on whether consumers keep their wallets open through the back half of 2023. Here, resilience is a double-edged sword. If spending holds up, it’s unlikely the Canadian economy will tip into a recession, at least in the near term. But that could mean more rate hikes from the Bank of Canada, which is actively trying to slow down spending to control inflation.

There are signs that consumers are starting to retrench. May retail data, published by Statistics Canada last week, were weaker than expected and pointed to no growth in June. And while discretionary spending on services such as travel and restaurants remains strong – a continuation of the “revenge spending” that started after pandemic lockdowns ended – people are dishing out less on non-essential goods.

Some economists argue the Bank of Canada is overestimating the current strength of household demand, and underestimating how quickly people will pull back in the coming months, making the last two rate hikes, in June and July, unnecessary.

Interest rate hikes, after all, work with a lag. And so far, only a third of Canadian mortgage holders have seen their monthly payments increase, meaning much of the impact of higher interest rates on household finances has yet to be felt.

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So far only a third of Canadian mortgage holders have seen their monthly payments increase, meaning much of the impact of higher interest rates on household finances has yet to be felt.DARRYL DYCK/The Canadian Press

Becky Western-Macfadyen is seeing that lag time in action. The St. Catharines, Ont.-based financial coaching manager with Credit Canada has been helping clients manage inflationary pressures over the past two years. More recently, she’s been fielding calls from homeowners with fixed-rate mortgages who are expecting their payments to jump by $500 to $1,000 a month in the coming quarters.

“It’s no longer just about, ‘Oh, I can just cut out my coffee spending.’ Everyone’s already done that stuff. So we’re finding so many more people have already cut what they can and they’re really at that bare bones,” Ms. Western-Macfadyen said.

There are, however, several factors that have supported consumer spending to date, and may continue to do so. Unemployment remains low and wages are rising quickly. Many households also built up considerable savings early in the pandemic that have yet to be run down.

Then there’s the high level of immigration. Canada’s population grew by 1.2 million over the past year, and it is expected to keep growing rapidly. That’s adding a record number of new consumers to the economy, who are supporting overall demand for goods and services even as per capita spending flatlines or declines.

“It’s just a matter of time before we see [a decline in spending] on the service sector side,” said Carrie Freestone, an economist at Royal Bank of Canada. “But if population growth continues to be exceptionally strong, then in nominal terms, we may not be in a situation where we see a drastic pullback in spending on the headline numbers.”

Indeed, population growth could help explain why the robust overall spending numbers don’t necessarily jibe with what many Canadians are feeling, said Stephen Tapp, chief economist at the Canadian Chamber of Commerce.

“It’s kind of the mirror story of the real GDP per person, which has done really badly in Canada,” Mr. Tapp said.

“It’s both true that the economy is growing, but on a per person basis, per capita, real spending in our data set is negative, and has been negative since the middle of March. So that’s one area where people may not feel like they’re doing all that well.”

A lot will come down to the health of household finances. And here the picture is mixed.

At a high level, Canadian budgets are in surprisingly good shape. Mortgage delinquency rates are at a record low, even for variable-rate mortgage holders who have been squeezed the most by interest rate increases. Non-payment on other types of debt, such as credit cards and auto loans, is rising, but remains for the most part below prepandemic levels.

“I would say things are deteriorating slightly, but still better than expected,” said Matthew Fabian, director of financial services research and consulting at the credit reporting agency TransUnion. “Given the rate hikes, given inflation, given all those kinds of pressures that are on consumers, we would have expected things like delinquency rates to be a lot higher.”

In its most recent Monetary Policy Report, published earlier this month, the Bank of Canada estimated that around three-quarters of households have considerably more “liquid savings”– cash or easily sellable assets – than before the pandemic. That’s hardly conducive to a sudden collapse in consumer demand.

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Photo illustration by the Globe and Mail/iStockPhoto / Getty Images

But there are significant pockets of stress. The proportion of credit cards hitting their spending limit, for example, is at an all-time high for people without mortgages. And the aggregate numbers gloss over the financial strain many Canadians are feeling, particularly low-income households that have been hurt the most by rising prices for essentials such as food, gasoline and rent.

Then there’s the fact that rate hikes don’t affect everyone equally. Statscan’s analysis of “net property income” – that is, interest earned on assets minus interest paid out on debt – shows that the top 20 per cent of households by income actually benefited from rising interest rates between first quarter of 2022 and the first quarter of 2023.

In effect, they earned more from deposits and other financial assets than they lost on higher mortgage costs. Everyone else saw their net property income fall, with the lowest-income households suffering the most.

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Canadian mortgage delinquency rates are at a record low, even for variable-rate mortgage-holders who have been squeezed the most by interest rate increases.COLE BURSTON/The Canadian Press

That raises an important question: Are the households that are driving the surprising strength in consumer spending the ones that are most likely to be affected by higher interest rates?

It’s hard to get a straight answer to this from the data, said Amanda Sinclair, a senior analyst with Statscan. But you can draw reasonable conclusions, she said.

“We know that lower income households do tend to spend proportionately more of their total income on the so-called necessities, like food and shelter costs and things like that. So we could deduce perhaps that they might not be the ones purchasing vehicles or travelling abroad,” she said.

It also appears to be a regional story. Rate hikes are hitting provinces with large urban centres, such as Ontario, British Columbia and Quebec, more than others, according to the net property income data from Statscan.

That makes intuitive sense to Mr. Tapp of the Chamber of Commerce. Ontario and B.C., in particular, have the country’s two most expensive housing markets: Toronto and Vancouver.

“The areas where you think you’d see the canary in the coal mine, it should be the areas where there’s a lot of households that are overstretched and particularly those who took on variable mortgages,” he said.

That could help explain some of the divergence in spending across the country, which the Chamber’s Business Data Lab highlighted in a report last week, based on credit and debit card data from payments processing company Moneris. Spending remains strong across the Prairies. Not so much in Ontario, Quebec and B.C.

Most economists think consumer spending is bound to slump over the remainder of the year, given the delayed impact of interest-rate increases. But there is a multibillion-dollar question hanging over these forecasts: What will happen to the “excess savings,” as economists call them, that Canadian households accrued early in the pandemic?

Unable to spend on restaurants and vacations, and bolstered by generous support cheques from the government, Canadians saved money at much higher rates through the first two years of the pandemic. That led to a buildup of household deposits held at banks, which grew by $333-billion between the end of 2019 and 2022, according to analysis by economists at Bank of Montreal.

Unlike in the United States, where elevated bank deposits have been declining over the past year, Canadians are still sitting on large amounts of these excess savings. This is concentrated among high-income households and much of it has been shuffled from demand deposits into interest-bearing term deposits and GICs. The question, hotly debated by economists, is whether this money will power more consumer spending in the future.

“There is this big pile of excess savings out there, and people could be using that to sort of finance consumption growth. But most of the aggregate signs point to three-quarters of the income distribution not really doing that in a meaningful way,” BMO senior economist Erik Johnson said.

“So yes, excess deposits could still come to the rescue,” he said. But there’s also a chance that households that are expecting higher mortgage expenses could simply sit on this extra money. “It could be a world where you have a lot of what we’d call buffer stock or precautionary savings,” he said.

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Governor of the Bank of Canada Tiff Macklem and his team are grappling with the question of why the economy has not cooled as much as they expected.Ashley Fraser/The Globe and Mail

The Bank of Canada, for its part, believes that this savings buffer is blunting the impact of tighter monetary policy. A summary of the discussion by the bank’s governing council ahead of the July 12 rate decision showed Governor Tiff Macklem and his team grappling with the question of why the economy has not cooled as much as they expected.

“Governing Council agreed that, on balance, consumption should moderate as higher interest rates continue to work through the economy,” the summary of deliberations said.

“But this moderation will take longer than previously anticipated given the stronger-than-expected momentum in consumption in the second quarter and the combination of a still-tight labour market with accumulated savings by households.”

Similar discussions are happening at central banks around the world. After a mad dash to raise interest rates, policy makers are entering a period of fine-tuning – scanning the data to see if they’ve done enough to bring inflation back to 2 per cent, while trying to balance the risk of doing too much and crashing the economy.

“We knew when we started raising rates that it was going to be really hard to assess how much would be enough to cool off consumer spending,” said Tim Lane, a former Bank of Canada deputy governor, who retired last September, five rate hikes into the current tightening cycle.

For one, it was unclear when interest rates would become properly restrictive, given the unpredictability of household and business inflation expectations, he said. There was also considerable uncertainty about how the buildup of savings would affect spending, and how long it would take for postlockdown revenge spending to wane.

“You had a whole set of models where all the parameters were estimated in a period when there was little or no inflation. And so clearly, those models were not going to be very reliable,” he said.

In short, you can add the strength of consumer spending to a growing list of things central bankers underestimated over the past few years – a list that includes, most prominently, the momentum of inflation in 2021 and early 2022. But it’s harder to say that it’s a bad thing in itself.

Consumer Price Index inflation in Canada has fallen to 2.8 per cent from a high of 8.1 per cent, while the economy continues to grow and unemployment remains low. That’s increased the odds that the Bank of Canada can achieve its vaunted “soft landing,” in which inflation returns to the 2-per-cent target without a major economic downturn.

“It’s good news,” Mr. Lane said of the economic resilience. “But what’s not good is that it’s not sustainable.”

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