After strong first-quarter GDP growth of 5.6% (annualized) in Canada, a third wave of COVID-19 disrupted the economy, according to preliminary data by Statistics Canada, and caused a contraction in April--the first monthly decline since April 2020. With many social restrictions persisting into May, S&P Global Ratings revised down the forecast for second-quarter growth to 1.9%, from 5.5% (1). Risk to our second-quarter forecast is tilted downward, as preliminary estimates for retail sales in May published after we completed our forecast suggest that restrictions were more of a drag on retail spending than we expected.

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However, the worst appears to be over, with coronavirus caseloads declining, vaccinations picking up (see chart 1), and provinces beginning to gradually lift restrictions in June. Seated dining booking through the Open Table app started to grow again in June after a two-month setback, an early indicator that activity and employment for the accommodation and food services sector will rise in June (see chart 5). The CFIB Small Business Barometer, a measure of small business confidence in the next 12 months, rose to 70.1 in June--a solid increase from 66.2 in May--with firms' near-term hiring plans continuing to strengthen (the highest reading since May 2016). Consistent with relaxation of restrictions, concerns about insufficient domestic demand eased further in June. This sets the stage for a stronger rebound in consumer demand-led GDP growth this summer. We revised up our third-quarter GDP growth forecast to 9.3%, from 3.5%.

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Services Sector Rebound To Accelerate In Second Half

We continue to assume that a "full-vaccine" economy will materialize late summer. In the second half of the year, we should see a pivot in the economy away from housing and durable goods consumption to the services sector, especially high-contact businesses still reeling from the pandemic. The rebound will accelerate in the second half (compared with the first half of the year) as touch-sensitive businesses make up lost ground as reopenings fulfill some of the pent-up demand in activities. Consumer spending growth likely will come close to double digits (9.8%) in July-September, given the outlook for vaccinations and openings.

We anticipate the economy to close the output shortfall, versus the fourth quarter of 2019 (pre-pandemic peak), in the third quarter of this year. But the larger setback in some touch-sensitive industries translates to a longer recovery for them (likely late-2021/2022).

Barring another meaningful rise in virus cases (the Delta variant poses a key risk as it's starting to spread in the U.K. where the share of fully vaccinated is much higher than in Canada), the economy is poised to grow 6.1% on average in 2021 (was 5.5%).

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The upward revision to our March forecast for this year's GDP growth is primarily owing to higher-than-forecasted first-quarter growth, upward revision to our U.S. growth forecast (and the rest of the world for that matter), and the federal government's additional stimulus outlined in April's budget announcement (see chart 9). S&P Global Economics now expects real GDP growth in the U.S. to come in at 6.7% and 3.7% in 2021 and 2022, respectively, revised up from 6.5% and 3.1% in its March report. (see "Economic Outlook U.S. Q3 2021: Sun, Sun, Sun, Here It Comes," June 25). The more generous government support and investment plans are likely to also provide a stronger than previously anticipated growth impulse next year--which explains some of the upward revision to our 2022 growth forecast to now 3.2%, from 2.4%. We continue to expect home price growth should weaken from its current unsustainable double-digit pace as the year progresses. And while robust housing permits point to further near-term strength in housing starts (well above pre-pandemic trend), we anticipate starts to ease back down towards pre-pandemic run rate next year and beyond. Our GDP growth forecast revision implies a smaller GDP shortfall at the end of our forecast (2024) from the pre-pandemic path (compared with March forecast).

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Risk To Recovery Forecast Dependent Largely On Consumer Spending

Risks to our forecast in 2021 and 2022 are balanced. Another wave of COVID-19 and low tolerance to keep the economy open continue to pose downside risk to consumer spending, and subsequently, GDP growth. Alternatively, a larger share of households' accumulated savings (see chart 10) could go toward consumer spending in the coming quarters (2). Our baseline forecast currently anticipates that households will spend some of their savings while maintaining a savings rate approximately 3x higher than they did before the pandemic--admittedly, a conservative assumption. Uncertainty on distribution of so-called "excess" accumulated savings and how Canadians will spend their extra money remains very high. If they show greater initiative in dipping into their savings, consumer spending would be larger than in our baseline forecast this year and in 2022 and, in turn, pave a higher recovery path for GDP (3).

Growth will likely remain robust, averaging 2.8 in 2022-2023, enough to bring the unemployment rate back down to pre-pandemic rates--below 6%--by late next year (see chart 11). Although payroll employment looks to recover to pre-pandemic levels in the third quarter of this year, it wouldn't fully recover to its pre-pandemic trend path before the end of 2023, considering missed employment growth because of the pandemic (see chart 12).

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Inflation Likely To Be Transitory

In Canada, inflation, as measured by the Consumer Price Index, reached 3.6% year over year in May, edging up from 3.4% in April (see chart 13)--surpassing the upper limit of the Bank of Canada's target range (1%-3%). Inflation in energy prices played a large role in the uptick but inflation moved up even when excluding energy (2.2% in May from 1.6% in April). What has been surprising is that month over month annualized rates have clocked in above 6% on average the last couple of months, even when demand was largely under facing headwinds from social restrictions, signifying the importance of supply side pressures. The Bank of Canada's core inflation measures were all up as well in May (see chart 14), with CPI-trim, CPI-median and CPI-common rising to 2.7% (from 2.3%), 2.4% (from 2.3%), and 1.8% (from 1.5%), respectively.

Inflation has been a talking point for several months in Canada as well as south of the border. The acceleration of inflation has come faster than expected. Supply hiccups, directly and indirectly, to pandemic-sensitive sectors such as transportation, autos, and airlines have constrained capacity to meet the demand. The pickup in inflation in Canada has run somewhat behind the U.S., but it has come even as pandemic restrictions continued to restrict activity in high-contact industries. Shelter prices look to pick up more as homeowners' replacement costs continue to move up, and a semiconductor shortage will likely persist through this year to provide inflationary pressures in autos and electronics (like laptops and cell phones). It will take the remainder of 2021 to iron out supply-side pressure to meet the opening up of demand.

We think the 3%-4% handle seen in the last couple of months should give way to 2% handles next year. The supply-side price pressures driven by transitory supply-demand mismatch will fade next year and more traditional demand-push forces from the economy getting closer to full employment by the end of 2022 will help keep inflation slightly above 2% in 2023 and 2024.

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Monetary Policy Liftoff Likely A Late 2022 Event

With second-quarter GDP growth set to be weaker than the central bank expected, and the Bank of Canada Governor Tiff Macklem concerned about the strength of the Canadian dollar, policymakers are unlikely to take a more hawkish approach to interest rates or cut asset purchases materially in their July meeting. We now assume the first policy rate hike will come toward the end of 2022 (versus the first quarter of 2023 and versus market pricing mid-2022), consistent with our forecast of a headline unemployment rate of 6% by then, and with core inflation consistently around 2% (see chart 15). We expect the next quantitative easing reduction (to $2 billion per week) announcement (third since last October) to take place at the September meeting (contingent on two good jobs reports after April and May job losses).

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Endnotes

1) Closure of non-essential stores and stay-at-home orders weighed heavily on retail activity in April, with sales plunging by 5.7% month over month. The headline was slightly weaker than Statistics Canada's preliminary forecast, which called for a pullback of 5.1%. Looking ahead, Statistics Canada's flash estimate suggests that restrictions continued to exert a drag on retail activity in May, with sales declining by 3.2% in that month.

2) Excess savings are estimated by calculating how much households would have saved in 2020 if they had saved the same share of their income as they did on average in 2018 and 2019, and income growth was set at 10 year pre-pandemic average. The gap between this and actual savings is assumed to be excess savings as a result of the pandemic. The majority of the rise was imposed on households.

3) Significant uncertainty remains on how built-up household savings (10% of GDP) will be unleashed in a more normalized economy. Some of it is surely earmarked for paying down debt either new mortgages or older debt). Risk to the consumer spending growth trajectory clearly rests on how fast Canadians will spend their excess savings when the economy gets back to pre-pandemic "normal" capacity.