This week’s chart highlights the delayed impact of higher interest rates on the economy. The dark blue portion of the bar graph represents the impact of interest rate increases which have been felt by the economy.
The red portion represents the impact which has not yet been felt by the economy. An increase in interest rates has a delayed impact on the economy for several reasons: some debt has a fixed interest rate which re-sets over time, consumers tend to draw-down savings before they reduce spending when the cost of debt increases, initial cost of borrowing increases are passed on to consumers through higher prices whereas later increases begin to reduce demand, etc.
You can overlay this logic with your personal experience. When the Bank of Canada increased interest rates in March of 2022, it likely didn’t have an immediate impact on your life or spending habits.
However, now that we’re ~19 months into this rate hiking cycle, you have likely experienced the impact of higher rates through higher mortgage payments, higher rent, consumers spending less at your business, etc. As you would expect, the chart shows that the first increases made in the spring of 2022 have been almost fully reflected in the economy.
Conversely, the rate increases made this year have yet to be meaningfully reflected in the economy. As shown in the chart, the National Bank Financial Economics and Strategy team estimates that 42% of the impact of interest rate increases have yet to be felt.
The most recent Canadian economic data confirms that our economy has begun to slow due to the cumulative impact of interest rate increases. Canada’s most recent inflation data (CPI) showed a decrease of 0.1% relative to expectations of an increase of 0.1% for the month of September.
The Bank of Canada’s preferred measures of inflation (CPI-trim & CPI-median) also came in below expectations in September. Furthermore, the most recent retail sales data declined by 0.1% for the month of August.
This headline decline of 0.1% doesn’t tell the entire story given Canada’s historic increase in immigration levels. On a per capita basis, retail sales fell much further.
When our economics team annualizes August’s retail sales data and adjusts for population growth, we estimate retail sales declined by 5.7% in the third quarter which would be the worst quarterly performance since the first pandemic lockdown.
If the economy has begun to slow and over 40% of the impact of higher interest rates has yet to be felt, it is very likely that the economy will continue to slow into 2024.
The million-dollar question is, will inflation get back to the Bank of Canada’s 2% target, allowing them to reduce interest rates, before we experience a more substantial decline in economic activity. To quote the Governor of the Bank of Canada, Tiff Macklem, “the path to a soft landing has become very narrow.”
Eric Van Enk is a wealth adviser & associate portfolio manager with National Bank Financial in Medicine Hat. He is a graduate of the University of Calgary, as well as a CFA charter holder with 20 years of financial markets experience in New York, Toronto and Calgary. He can be reached at eric.vanenk@nbc.ca
