Canada’s economy is eroding at an unusually fast rate, and financial conditions are tightening. Oxford Economics, a global macro research firm, warns their recession index shows a recession is almost certain at this point. It’s unlikely to be a brief one either, with the central bank unable to rely on lower rates due to high inflation. At this time they don’t expect a financial crisis, but it can no longer be ruled out.
Canada’s Indicators Warn A Recession Is Coming
Canada’s recession indicators are flashing a code red, according to the firm. “Our new Canada Financial Conditions Index (FCI) shows a sharp, broad-based worsening of financial conditions and is yet another worrying sign that the economy is on the cusp of recession,” said Tony Stillo, the director of economics at the firm.
The index has a track record of identifying periods of economic stress, notably surging in 2007, preceding the Great Recession. At the onset of the pandemic in March 2020, it also indicated the incoming stress would be more serious than thought at the time. Now with the tightening of financial conditions in 2021, it indicates a recession is coming — and it won’t be mild.
The Bank of Canada Won’t Be Able To Cut Rates Due To Inflation
Many people are expecting the erosion to translate into rate cuts, but that’s not an option this time. “Such a noteworthy tightening of financial conditions might normally give the Bank of Canada (BoC) reason to pause its most aggressive rate tightening campaign in decades. But the BoC is steadfast on quelling inflation and preventing a wage-price spiral, meaning we don’t think a dovish pivot is likely,” he said.
A wage-price spiral would be a disaster for the economy. Typically wage increases and the price of goods and services move together. That should make sense, since the people that work to produce goods need their income to support their life.
Currently inflation is soaring at unusually high levels, crushing wage earners. To accommodate this, wages need to soar or prices need to fall. Wages would need to rise much more than prices can absorb, resulting in even more inflation. That would turn into even higher prices, and require even more price increases, which… you get the picture, it “spirals” higher. The ultimate end is a recession in this case, it just takes a little longer and creates more systemic issues along the way. The other option is some of the inflation rolls back, which is what central banks would prefer. A moderate recession instead of a systemic crisis seems like a strong trade off.
Expect Interest Rates To Climb Further
Consequently, the firm is forecasting higher rates and tighter financial conditions, despite the worsening environment. At this time, they expect another 50 basis point hike to the overnight rate in October, making a 3.75% policy rate. It would be the highest since 2008, before pausing to assess the economic fallout. The firm warns this is well into restrictive territory, especially with quantitative tightening to shrink its balance sheet by 5% of Canada’s GDP by 2025.
“Tighter financial conditions are worrisome given the Canadian economy’s extremely elevated household debt levels and heavy reliance on the housing sector – which is already in recession. We still view a financial crisis as highly unlikely, but it cannot be ruled out,” warns Stillo.