Canada's economic growth was better than S&P Global Ratings expected in the second quarter, leading us to revise our forecasts, but the pace of expansion remains short of the country's potential.

Real GDP on an expenditure basis was up 2.1% quarter over quarter, against the 1.6% we expected, following 1.7% in the first quarter. On a year-over-year basis, the economy expanded 0.9% in second-quarter 2024.

In the first half, annualized growth reached 1.95%, which was better than the 0.17% average over the last three quarters of 2023. Yet despite the pick-up in momentum, real GDP growth on a per-capita basis has now dipped below zero in seven out of the past eight quarters.

We now expect real GDP growth of 1.2% this year, from 1.1% previously, below the longer-run potential pace of 1.8%. However, lower interest rates should help drive a recovery to 2.0% in 2025, up from the 1.7% we forecast in our third-quarter publication.

We think the rebound in economic growth will mainly come from fixed investment--both residential and nonresidential--rather than consumer spending. The monetary easing cycle that began in June will help flip investment outlays from contraction last year to expansion in our forecast horizon. This shift may not be dramatic, but is it is much needed after the malaise of recent quarters.

In our view, the cumulative lagged effect of higher interest rates will continue to weigh on consumers. Even though the BoC has started an easing cycle, borrowing costs will remain much higher in the next two years than COVID-19 pandemic lows, partly due to the mortgage renewal system in Canada. Many homeowners will see interest payments as a share of income rise in upcoming five-year mortgage renewals over 2025 and 2026, relative to 2020-2021 contracts.

Changes to immigration policies and their effectiveness are key uncertainties in our baseline forecast, with the potential to curb the high aggregate consumption growth seen in 2022 and 2023.

Labor market

Labor market data since our previous publication reinforces the longer-term pattern of softening, which is consistent with modest growth in economic activity. Notably, the underlying trend since May has been one of weaker hiring and rising unemployment.

The Labor Force Survey (LFS) measure of wage growth was 5.0% year over year in August. Meanwhile, the BoC's preferred measure, quarterly earnings, points to a 3.8% year-on-year increase in total hourly compensation in the second quarter, with a finer breakdown showing just 2.9% growth in the business sector versus a longer-run average of 3.4%. No matter the measure though, productivity growth is running well behind wage growth, which is inconsistent with 2% inflation.

In August, employment increased 22,000 after two consecutive monthly declines, but the past three months was still weaker on average than the preceding three. Hours worked also fell over the past three months compared to March-May as full-time employment declined.

The combination of weaker hiring demand and rising labor supply led unemployment to reach 6.6% in August from the 6.2% average in the second quarter and 5.9% in the first. Much of the increase so far this year is due to longer job searches for new labor market entrants (particularly students) but layoffs are also rising.

We expect continued strong labor supply growth will push the unemployment rate closer to 7% by year-end 2024 before reversing course in first-half 2025 as GDP growth accelerates above potential.

Inflation

Headline inflation was already 2% year on year in August and core measures, albeit above target, continue to move lower as well. Goods prices were down 0.7% year on year (deflation) while services prices were up 4.3%. Notably, shelter prices are keeping service inflation relatively high, with rental rates up 8.6% year on year and mortgage interest costs 18.8%.

That said, the BoC's preferred core inflation measure decelerated to 2.4% year on year in August and on a three-month annualized basis, while inflation excluding shelter was a paltry 0.5% year on year.

Higher unemployment coupled with persistent declines in per-capita GDP will help push inflation lower. We anticipate core consumer price index (CPI) growth of 2.0%-2.5% in the next 12 months, but with risks of undershooting 2.0%. In particular, further rate cuts will cause mortgage-fueled inflation to decline sharply for the rest of the year.

Monetary policy

On Sept. 4, 2024, the BoC cut the overnight interest rate by 25 bps for a third consecutive meeting, in line with our and the market's expectations. However, the current policy rate is still relatively restrictive compared with our longer-run estimate of neutral and against a backdrop of economic growth that is below potential.

Communications from the bank following the September meeting reiterated that further cuts are likely, which highlights a shift in focus to downside risks to the economic growth outlook now that inflation is slowing. Some of the strength in second-quarter GDP was discounted and partly attributed to government spending. In his post-meeting press conference, BoC governor Tiff Macklem stressed that policymakers "need to increasingly guard against the risk that the economy is too weak and inflation falls too much".

That said, the BoC didn't entirely abandon its previous messaging that rate cuts would be made one meeting at a time and continued to highlight concerns around elevated shelter and services inflation. In its policy statement, the bank noted that wage growth remained elevated relative to productivity, and that price increases in shelter and some other services were preventing inflation from decelerating. We think this means there is a high bar for larger 50 bps cuts, for now. This may include a sudden sharp deterioration in activity and labor market data between now and the October meeting, or large downside surprises in the August and September CPI reports--and evidence of slower services and shelter inflation in particular.

With its renewed attention on downside risks, we expect short-of-potential GDP growth--estimated by the BoC at 2.4% for 2024 and 1.9% on average over 2025 and 2026--and easing inflation will prompt a steady course of 25-bps cuts in the meetings through the fourth quarter and January. Then shifting to an every-other-meeting cadence beyond that. This would lower the policy rate to 2.5% by December 2025, the middle of the BoC's neutral rate estimate (published in July), but modestly stimulative, in our view.