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Shoppers crossing the CF Toronto Eaton Centre Bridge Eaton Centre in downtown Toronto on July 12.Fred Lum/The Globe and Mail

Canadian shoppers appear to have cut back on spending through the middle of the summer, suggesting that consumer demand is starting to fall as high inflation and rising interest rates take a bite out of purchasing power and weigh on consumer confidence.

Retail sales dropped 2 per cent in July, according to a preliminary estimate published by Statistics Canada on Friday. This number will be revised next month. If it holds, July could mark a turning point after six months of consecutive growth in retail sales that accompanied the reopening of the Canadian economy from pandemic lockdowns.

“That weakness is hardly surprising following the recent slump in consumer confidence and the [Bank of Canada’s] 100 basis point policy rate hike in July which, overnight, raised households’ interest obligations by 0.7 per cent of their income,” Stephen Brown, senior Canada economist with Capital Economics, wrote in a note to clients.

The apparent decline in July follows a 1.1 per cent increase in retail sales in June, Statscan reported. This came in ahead of expectations, led by higher sales at gas stations and car dealerships. That said, much of that gain was the result of rising prices, particularly for gasoline. In volume terms adjusted for inflation, retail sales grew by a less impressive 0.2 per cent that month.

Gasoline prices seem to have had the opposite effect in July, with falling pump prices that month apparently reducing the value of retail sales. But economists say that the pull back is the result of more than just a drop in gas prices.

“Some of that can be chalked up to lower gasoline prices, but the majority looks to be due to consumer fatigue,” Royce Mendes, head of macro strategy at Desjardins Securities, wrote in a note to clients. “Canadians have been feeling the pinch from both high inflation and rising interest rates. So it should come as little surprise that retailers are beginning to see the pace of sales slow.”

Consumer spending held up remarkably well in the first half of the year, despite inflation rising to a four-decade high and the Bank of Canada embarking on an aggressive campaign to raise interest rates in March. That’s partly the result of resurgent demand for travel, recreation and entertainment, as those sectors reopened after pandemic restrictions.

Toronto Dominion Bank economist Ksenia Bushmeneva noted that spending on high-contact services continued to trend up through July, according to TD debit and credit-card data. Spending on travel in July was nearly twice as high as last year, while spending on recreation and entertainment was up 27 per cent year-over-year, Ms. Bushmeneva wrote in a note to clients.

At the same time, she said she expects this type of consumption to slow in the coming months. “The easing in spending patterns for goods and services categories that were not restrained by the pandemic, suggests it’s only a matter of time before the same occurs for high-contact services, once pent-up demand is satiated,” she said.

“We expect that the trifecta of financial headwinds: red-hot inflation, higher interest rates and an erosion of household wealth, will soon force consumers to tighten their belts, and many of these ‘fun’ activities are discretionary.”

The Bank of Canada will be watching the retail data closely for signs that interest rate hikes are starting to influence consumer demand for goods and services. The central bank has raised rates by 2.25 percentage points since March with the express purpose of cooling down demand in the economy in an effort to slow the pace of consumer price growth. Economists expect it to follow up with another 0.5 or 0.75 percentage point rate hike in September.

“Rate hikes have been making their way through the housing market and now seem to be cooling demand for retail goods as well,” wrote Mr. Mendes of Desjardins.

“We’re still in the early innings of a slowdown, with much of the lagged effects of prior rate hikes yet to be felt. So while the Bank of Canada will be delivering more rate increases, they can look to numbers like these as signs that their prior tightening is beginning to work as intended.”

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