Since our last Credit Conditions Committee meeting (in June), the Canadian economic recovery has been slower than we expected. The economy, as measured by real GDP contracted 1.1% quarter-over-quarter (annualized) in the second quarter (following 5.5% growth in the first quarter)--weaker than our 1.9% growth forecast. Preliminary estimate from Statistics Canada suggested a weaker-than-anticipated July to begin the third quarter, and there are signs that growth in the U.S.--Canada's major trading partner--will also be softer in the third quarter than previously forecast. (S&P Global Economics has revised U.S. real GDP forecasts for 2021 and 2022 to 5.7% and 4.1%, respectively, from 6.7% and 3.7% in our June report.) For these reasons, along with increased caution regarding the COVID-19 Delta variant and lingering supply bottlenecks, we revised our full-year 2021 growth forecast for Canada to 5.4%, from 6.1% in June.

We expect a revival of relatively strong, growth in the second half--of 7% annualized--on sustained reopening of the economy (albeit only gradually), which would bring the real GDP to its prepandemic level in the fourth quarter. As the current (fourth) COVID wave ebbs and supply chain wrinkles iron out, the gains from reopening will shift the 2021's delayed growth into 2022. Businesses will continue to rebuild depleted inventories and nonresidential investment outlays will contribute strongly to growth. We revised up our 2022 growth forecast by 0.4 percentage points to 3.8%, followed by 2.1% average growth in 2023-2024 (more-or-less in line with our previous forecast).

Chart 1

The world is transitioning to live with the virus, and Canada is no exception. On the plus side, high vaccination rates should obviate the need for major social restrictions. Close to 70% of Canadians are fully vaccinated, well above 55% mark in the U.S. We assume the drag on spending from COVID-19 will not get worse than what we are experiencing today and will continue to wane.

Still, downside risks to our baseline growth forecasts from COVID-19 can't be dismissed just yet. The Delta variant may not represent the last assault by the virus and worsening fatalities could reverse some reopening trends domestically. Moreover, given close to a third of Canadian GDP is based on exports (versus less than an eighth in the U.S.), weaker-than-expected output growth could persist not just by domestic policy choices but also by governments overseas.

On the other hand, the Liberal Party retained a minority government in the September 20 federal election, which could possibly add a few percentage points to our 2022-2024 forecasts. Presumably, the Liberals will press on with the plans laid out in their election platform, which point to an increase in spending of C$8 billion over the coming five years, partially offset by an increase in revenues of C$25 billion.

Table 1

Inflation Risk Picks Up Further, But Still Looks Transitory

Recent developments have prompted us to revise our consumer price inflation forecast (year-over-year) for Canada up by a few 10ths of a percentage point for third-quarter 2021 through the second quarter of 2022.

Headline inflation accelerated to 4.1% year-over-year in August from 3.7% in July (the highest reading since May 2003), already surpassing the Bank of Canada's 1%-3%. Energy inflation remained the main driver of headline inflation, rising to an average 23% per month since March. In addition, shelter (which has the highest weights in the CPI basket) has also inched up since May this year. In shelter, an important element we saw in the past few months was homeowners' replacement costs, which is related to the price of new homes, jumped sharply to an average 12.2% per month since April, pushing the headline inflation further up (see chart 2).

Chart 2

Chart 3

The supply disruptions that have pushed up prices look set to last longer than we assumed. Upward pressure persists on food prices globally and very low vehicle inventories point to further upward pressure on new vehicle prices to come. Maritime freight cost prices have also surged in the past several months. We now expect core CPI inflation to remain above or near 3% until the second quarter of next year (versus first-quarter 2022 previously).

Nevertheless, there are still several reasons why we expect inflation to drop back to 2% in the second half of 2022 (see chart 3). For a start, our oil and gas sector analysts assume oil price as measured by West Texas Intermediate (WTI) prices to fall to a $55 average next year from a $65 average this year. We also assume that freight rates will eventually decline to more-normal levels, and that prices of some goods will fall as supply constraints ease. Additionally, Canada, unlike the U.S., uses house prices directly in its CPIs, meaning this component will weigh on overall price growth--consistent with our forecast for cooling housing activity from the current unsustainable levels that will manifest in a sharp decline in house price growth next year.

We think supply-side price pressures driven by transitory supply-demand mismatches will fade next year and more-traditional demand-push forces from the economy will get closer to providing full employment by the end of 2022 (see chart 4), keeping inflation slightly above 2% in 2023-2024.

Chart 4

Chart 5

Monetary Policy Rate Hike By Fourth-Quarter 2022

There is, of course, still substantial uncertainty about how inflation will develop, meaning the Bank of Canada will remain focused on developments in the labor market. We anticipate the unemployment rate to decline to 6.7% in fourth-quarter 2021 (versus 7.2% currently) and 6.0% by the end of 2022 (see chart 5). In its September meeting, the Bank maintained its forward guidance that the overnight rate will remain at its current level until the economy returns to full capacity. In the context of our forecasts for the economy, we continue to pencil in a fourth-quarter 2022 policy rate lift-off.

Table 2