Fast-rising interest rates are likely to dent the housing market, raise debt service costs and slow consumer spending, but a major recession is not currently in the cards, TD Economics says.
In a new report examining the latest economic and financial outlook, economists at the bank assess the likely impact of a slew of recent negative developments, including high inflation, rising interest rates, and the ongoing war in Ukraine.
“The global outlook has soured since last quarter’s update,” the report noted.
Russia’s invasion of Ukraine and its impact on both commodity prices and global supply chains are key reasons for the grimmer outlook — as is the slowdown in China due to the fallout from its ongoing measures to fight the pandemic.
The key impact of these factors in Canada is high inflation, which is driving rate hikes that are expected to have some significant effects on households.
The report forecasts that debt service costs will start rising along with interest rates, and that consumer spending will slow due to the negative effects of inflation on purchasing power.
“For example, according to the Bank of Canada estimates, 5% inflation will cost Canadians on average $2,000 more per year compared to 2% inflation,” the report noted.
And TD estimates that higher interest rates will increase annual debt servicing costs by about $2,400 per household by the first quarter of 2023.
At the same time, “Housing markets have begun to soften under the weight of higher rates,” the report said.
In fact, TD now forecasts that, by the fourth quarter, Canadian home sales will drop by 25%–35% on an annual basis, “as interest rates ratchet higher, before making up lost ground in 2023.”
The weakening in activity is expected to result in average home prices dropping by about 8% in the fourth quarter, which would leave them down 15% from peak levels.
“To put this in perspective, given the massive price gains seen through the pandemic, that would leave the average home price still about 25% above its pre-pandemic level. This is not so much a market correction as it is a recalibration,” the report said.
Indeed, despite the growing pressure on households, the report does not see higher rates pushing the economy into recession.
“Based on several key forward-looking data or risk metrics, an imminent recession is not forthcoming,” it said.
Despite recent developments, the report noted, “The yield curve is positively sloped, indicators such as ISM indices are firmly in expansion territory and the labour market is exceedingly tight.”
Additionally, households have a cushion in the form of excess savings accumulated during the pandemic.
At this point, the bigger risk is that households and businesses talk themselves into a recession, the report suggested.
“Perhaps the greatest threat to the cycle at this time is the increased speculation of recession within the media and business circles that can negatively influence spending behaviours and enhance market volatility, setting in motion the dynamics that are least desired,” it said.
Yet, even if rate hikes do overshoot a bit and brake the economy too hard, the report suggested that the slump would likely be shallow.
“Given that the U.S. economic cycle lacks the leverage excesses and the risky financial assets of 2008, a policy miss would more likely land the U.S. into shallow recession territory given that American households are in far better position to withstand pressure,” it said.
“In fact, since economic growth needs to recalibrate below potential to ease pressure on inflation, if [monetary policy] were to marginally overshoot and [the economy] tread water in shallow negative territory for a short period, this should accelerate the recalibration,” it added.