The Canadian Economy: Analyzing Past Trends to Forecast Future Outlook

The Canadian economy is cooling off after a period of “overheating” — a term economists use to describe excessive growth that strains resources. Following the far-reaching impacts of the pandemic, the economic outlook is now stabilizing, both in Canada and the U.S.

RBC economist Carrie Freestone revisits 2020 to shed light on the current economic landscape and offers insights on the future of both the Canadian and U.S. economies.

“It all started in 2020”

The current economic conditions are a direct outcome of the pandemic, Freestone notes. Subsequent economic shocks and the aggressive recovery efforts that followed highlight the complex and winding path both countries took to arrive at today’s position.

“Real GDP contracted by about 17% from peak to trough, and there were roughly 3 million jobs lost in Canada during the onset of the pandemic,” she explains. “At one point in May 2020, the unemployment rate in Canada reached 14%. That’s a very significant shock.”

What happened next was greatly increased demand in certain sectors, which set the stage for strong inflation. For instance, lumber was difficult to get during the pandemic due to the demand for home improvement projects and supply issues caused by COVID shutdowns. Later, restaurants faced higher food and labour costs, while patrons were willing to pay extra after spending months at home. When Russia invaded Ukraine, global oil prices increased rapidly.

Freestone recalls this period as it set the stage for double-digit food inflation in 2022. “When the Bank of Canada and the Fed realized inflation wasn’t going away anytime soon, they hiked interest rates very aggressively. This aggressive monetary policy worked to cool demand, but it did take time.”

Today, as inflation has returned to its target rate near 2%, the economic situation is starting to level off.

Are we in a recession?

One of the questions Freestone is often asked is if Canada is in a recession. Economic activity has slowed in Canada, and the country has a lower GDP per capita than similar countries. For many households in Canada, times feel tougher than ever.

Many economists, however, are saying that Canada is not in a recession, primarily due to the broader growth in the economy. Why?

“In Canada, we have had exceptionally strong levels of immigration over the last few years,” explains Freestone. “We have welcomed over 2 million new people to the economy since mid-2022, and each of those people are consumers. Immigration has managed to keep overall output from outright declining — I’m one of the economists who will comfortably say that if it hadn’t been for record immigration in the last few years, Canada would likely be in a recession right now.”

How the U.S. economy compares

For some time, the U.S. has been significantly outperforming Canada, primarily because Americans didn’t pull back their spending the way Canadians have.

One of the main reasons is that Americans are often less sensitive to interest rates than Canadians. For instance,  in the U.S., many people have longer-term mortgages, so it’s often cheaper and easier for them to renegotiate. This makes for an environment where homeowners may feel the impacts of interest rates less acutely than their Canadian counterparts. And while both Canadians and Americans had been sitting on record levels of pandemic savings, Americans have nearly depleted theirs. The fact that Canadians are instead expanding their savings is likely due to the recent interest rate environment and its effect on day-to-day purchasing power.

Freestone notes, however, that she is seeing some pull-back by Americans. “There are more risks than there were six months ago. We’re starting to see signs that manufacturing activity in the U.S. is a little weaker, and there is breeze building about U.S. labour markets.” She calls out the recent stock market crash in August — the result of unemployment rising at a rate consistent with past recessions — as an example of the potential cracks beginning to form. 

Headline inflation is reaching its target — what does that mean for Canadians?

The Bank of Canada’s inflation target is 1%—3% (the inflation rate was 1.6% as of September in Canada ). “While we are sitting in the sweet spot, I want to emphasize that 2% inflation in 2024 is very different from 2% inflation in 2019,” says Freestone.

The reason for this, she says, is that two-thirds of the consumer price index (CPI) growth — a primary indicator of inflation — came from mortgage interest costs and rent. “This is something no one is immune to. Everyone has to pay for shelter,” she notes. She adds that food prices are 25% higher than they were pre-pandemic, and while price growth for groceries has reached its target, it doesn’t mean prices are outright declining. “Even though inflation is at 2%, the pressures are felt by everyone. Before, in 2019, inflationary pressures weren’t necessarily universal because they weren’t all coming from shelter and food costs.”

While the environment in the U.S. is slightly different, Freestone notes that headline inflation is pulling lower south of the border as well. Following the first interest rate cut by the U.S. Federal Reserve, which was an aggressive 50 basis points, the price growth of CPI basket items reported was below the pre-pandemic average. Additionally, there has been slower energy price growth in recent months, pushing headline inflation lower. “These are all positive trends,” says Freestone.

Interest rate forecast: Signs point to more cuts

Freestone explains that indicators indicate further interest rate cuts by the Bank of Canada. One of these indicators is debt servicing costs, which are starting to rise for both businesses and consumers. Business insolvencies are starting to increase in Canada, driven in part by the fact that CEBA loans came due in January. On the consumer side of things, Canadians are spending a record share of their take-home pay on mortgage payments and servicing other debt.

“We’re in a situation now where the average household is spending close to 15% of their take-home pay on servicing debt. Prices in general are up 18%, and as a result, we are starting to see consumer spending in Canada getting a little softer,” says Freestone.  These indicators, combined with rising credit card utilization rates and delinquencies—– along with wage growth that has just barely caught up with inflation — lead Freestone to believe that interest rates will continue to come down. 

The unemployment rate is affecting those new to the labour force

Freestone notes that the unemployment rate has increased by 1.8%. While the current rate of 6.5% is an improvement from the approximately 14% seen during the height of the pandemic, people who were not previously working — such as students and newcomers to Canada — are finding it hard to find jobs. “We’re starting to see that it’s an extremely challenging time for university students and new graduates to find that first job,” she says.

In the U.S., meanwhile, the unemployment rate is rising from a particularly low level. Freestone and other economists are monitoring it to see what happens next.

The impact of the U.S. election

A new administration in the White House means the relationship between Canada and the U.S. will not be status quo. From tariffs to taxes, the new president’s to-do list is likely to affect Canadians to some degree — economists are keeping a close eye on just what the impact might be.

The CAD versus USD forecast

As the U.S. economy has been outperforming Canada’s, Freestone expects the Canadian Dollar to weaken in Q4 2024 and into Q1 2025. Further, since interest rates are materially higher in the U.S. relative to Canada, the U.S. Dollar is expected to strengthen. “Our expectation is that in Q4 and Q1, the CAD will average 71 U.S. cents — so a little weaker than it is today.” Freestone does expect, however, that the CAD will improve against the USD in the back half of 2025.

Housing affordability

Freestone notes that in Canada, housing affordability has been severely challenged. While demand for housing has been strong, there hasn’t yet been a big uptick in activity, even with recent interest rate cuts. Freestone predicts that this is because affordability is continuing to hamper activity. “Many people are finding it very hard to not only save for a down payment but also to qualify for a mortgage because, in many cities, the average price for homes is upwards of a million dollars in Canada.” 

Further, Freestone notes that Canadians are, on average, having to devote more than 60% of their pre-tax income in order to afford a home. In Ontario and B.C., it’s much worse, climbing upwards of 80%. “So, it’s very difficult for buyers to get into the market,” she says. 

While there has been some price correction since the market peaked in 2022, prices remain significantly above where they were at the beginning of the pandemic, and affordability continues to constrain many buyers. When asked if she expects a housing crash in Canada, Freestone believes that will not happen. “Demand is so strong. Even if many, many buyers are constrained, there are still some people who have access to down payments. Our population is growing very quickly, and we’re not building homes fast enough to accommodate this growth, so housing prices will continue to go up.” Having said that, Freestone does not expect to see the level of appreciation seen during the pandemic.

The bottom line

While inflation and interest rates are coming down, Canadians may continue to feel the pinch when it comes to everyday goods and housing costs in particular. But there are reasons to be optimistic: interest rates might provide relief for borrowers, housing costs aren’t expected to rise at the same pace they have in recent years, and young people looking for jobs may see some bright spots in 2025 as the labour market is expected to open up.

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