New economic data from Statistics Canada, covering the third quarter of 2022 (July through September) indicate that the recession feared by many forecasters has already started in Canada’s domestic economy. After a year of rapid slowing, real domestic demand (excluding international trade) shrank in the third quarter at a 0.6% annualized rate. After months of rapid interest rate increases imposed by the Bank of Canada to slow job-creation and economic activity, many components of domestic spending (especially those sensitive to interest rates) are now contracting. Household consumption, residential building activity, business machinery and equipment investment, and public sector investment all declined in the third quarter.
Despite the contraction in domestic demand, real GDP grew by a surprising 2.9% annualized rate in the third quarter. Some observers interpreted that as a sign of continued economic resilience, but that growth was solely due to a big increase in real export volumes (led by petroleum). At the same time, imports declined (due to the slowdown in domestic activity, which reduced demand for imported products), and that also boosted GDP.
A second consecutive quarter of record-breaking inventory accumulation also ‘helped’ the third-quarter GDP number. Canadian Businesses have added over $70 billion (2.5% of GDP) to inventories in the last 2 quarters – far and away beyond any other inventory accumulation in Canadian history. Usually, inventories expand when sales are weaker than businesses expected. So that will reverse in coming months as firms adjust to lower growth in domestic sales. Then an inventory drawdown will exacerbate future contraction in output.
It is also worrisome that nominal GDP actually fell in the third quarter, at an annualized 2.7% rate. The real growth that occurred was due solely to exports (mostly more oil exports), but oil prices fell faster than volumes increased. So nominal GDP contracted, as did the GDP price deflator (a measure of price inflation that considers all goods and services produced in the economy, not just consumer prices): it fell at a 5.4% annualized rate. In other words, average output prices are now falling, at their fastest rate since the end of 2008 (amidst the global financial crisis). The price deflator for final domestic demand (which measures the average prices of all output excluding international trade) slowed to just 2.25% annualized. That is a sign of easing inflation pressures, and is already within the Bank of Canada’s target range for inflation (the Bank aims to keep inflation between 1% and 3%). Eventually this moderation of inflation for produced goods and services will also show up in slower consumer price inflation.
Real household disposable income also fell slightly in the third quarter: it is now at its lowest level since 1Q20 (when COVID hit), and well below the pre-COVID trend. The supposedly ‘excess’ household spending power that was accumulated in the early months of the pandemic (thanks to COVID income supports) has now disappeared.
This new data refutes the Bank of Canada’s narrative that inflation is being driven by excess domestic demand (especially from an “overheated” labour market). Domestic demand has been weakening for a year, and now is shrinking outright. Supposed ‘excess’ household income that arose during COVID lockdowns (due to CERB, etc.) has disappeared. External trade is the only source of real economic growth at present. Price pressures from the global market are dominating inflation trends at home (as has been the case throughout the pandemic). Indeed, nominal GDP prices are now falling due to easing world commodity prices. Even excluding the trade sector, price increases for domestic output (the final domestic demand deflator) have moderated to a normal range.
In sum, this GDP report suggests that continuing to punish domestic purchasing power with higher interest rates to suppress inflation makes less sense than ever. Domestic spending is not the problem, and it’s already contracting. It is international price pressures dominating the course of inflation in Canada. They are not sensitive to domestic interest rate adjustments, and they are abating quickly anyway.