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

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The Canadian economy began to buckle under the weight of higher borrowing costs in the second quarter, bolstering the case for the Bank of Canada to hold interest rates steady next week.

Economic activity fell at an annualized rate of 0.2 per cent in the quarter, led by a drop in new construction, a slowdown in consumer spending, and a hit to resource industries affected by wildfires, Statistics Canada said Friday. A preliminary estimate for July shows gross domestic product was essentially unchanged that month, indicating the economy is flatlining as it moves into the second half of the year.

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The GDP numbers came in well below both Bank of Canada and Bay Street estimates, of 1.5 per cent and 1.2 per cent annualized growth, respectively, suggesting that higher interest rates may be weighing on economic activity more than previously appreciated. That may solidify the argument for the Bank of Canada to keep its benchmark rate steady at five per cent next Wednesday.

“With the fall in monthly GDP in June and the apparent stagnation in July setting a weak foundation for the third quarter, the Canadian economy may already have fallen into a modest recession,” Stephen Brown, deputy chief North America economist at Capital Economics, wrote in a note to clients.

A portion of the slowdown is the result of idiosyncratic factors. Numerous industries were affected by wildfires in June, including mining, rail transportation, oil and gas extraction, and accommodation, particularly RV parks and campgrounds. In April, a strike by federal government workers weighed on public-sector economic activity.

That said, there were plenty of signs of a more generalized slowdown in Q2, after a strong first quarter. The contraction was led by a 2.1-per-cent drop in housing investment, which included an 8.2-per-cent fall in new construction and a 4.3-per-cent pullback in renovations. Statscan said these declines coincided with the Bank of Canada’s resumption of monetary policy tightening in June, after a five-month pause.

Household spending also slowed in the quarter, growing 0.1 per cent compared with 1.2 per cent in the previous quarter. Shoppers balked at new passenger cars, furniture and outdoor recreation gear. This was offset by a bump in spending on new trucks, vans and SUVs, which are coming to market after an improvement in auto supply chains.

“While aggregate household expenditures edged up in the second quarter, spending per capita fell 0.7 per cent. In fact, per capita household spending declined in three of the last four quarters,” Statscan said.

Household demand has been a sticking point for the Bank of Canada, which is actively trying to curb consumer spending on goods and services to slow the pace of price increases. When the bank restarted interest-rate hikes in June, officials called out stronger-than-expected consumer demand as a significant reason for the move.

The latest numbers, alongside sluggish retail data, suggest that some Canadian shoppers are beginning to tap out.

Other drags on economic activity in the second quarter included a slowdown in business inventory accumulation, which grew at the slowest pace since the fourth quarter of 2021. Trade also weighed on GDP, with imports exceeding exports.

Bond yields fell after the report, with the two-year Government of Canada bond yield dropping around 10-basis points to 4.55 on Friday afternoon. (A basis point is 1/100th of a percentage point). Bonds yields have retreated in recent weeks after lukewarm data releases in the United States that have reduced the odds of another rate hike by the U.S. Federal Reserve in September.

Friday’s Statscan data is the last top-tier economic release before the Bank of Canada’s rate decision on Sept. 6. Other data have generally pointed toward a cooling economy. That includes the July jobs report, which showed Canada lost around 6,400 jobs that month, while the unemployment rate ticked up to 5.5 per cent.

Inflation, by contrast, is proving stubborn. Annual Consumer Price Index growth rose to 3.3 per cent in July, up from 2.8 per cent in June. Although there was a slight fall in core measures of inflation that filter out volatile price moves.

“Between the half-point rise in the unemployment rate, the marked slowing in GDP, and some cooling in core inflation, it now looks like rate hikes are over and done,” Doug Porter, chief economist at Bank of Montreal, wrote in a note to clients.

“Now, the Bank of Canada just has to be patient as they wait for inflation to come their way – but that could take some time, especially with oil prices backing up again.”

The central bank is trying to slow the economy enough to bring down inflation, without overdoing it and causing a painful recession. Its latest economic forecast, published in July, projects slow, but still positive GDP growth of around 1 per cent through the second half of this year and the first half of next year.