Relief from rising interest rates is finally in sight. Bond yields have started to fall and major central banks are expected to cut their policy interest rates in the coming months. Against this backdrop, what can we expect from the US and Canadian economy in 2024? Below we offer our thoughts.
The U.S. economy performed better than expected in 2023, consistently exceeding projections. Inflation has fallen considerably, and while global inflation has also fallen, it remains elevated.
In December, the Fed made a notable change to its policy stance. Its dot plots conveyed expectations for two additional 25 basis point rate cuts in 2024, signaling that the Fed is anticipating significant monetary policy easing in the near term. [In these dot plots, each member of the Federal Open Market Committee (FOMC) places a dot on a chart to represent their individual expectations for where interest rates will be in the future.]
At the December meeting, Fed Chair Jerome Powell downplayed the risk of a recession and highlighted improving inflation, suggesting that rate cuts should occur well before inflation falls to the 2% target. The bond market rallied on the expectation of a first rate cut as early as March, although the Fed has since attempted to temper these expectations.
While the U.S. economy showed strong performance in the third quarter of 2023, and the fourth quarter is tracking moderate growth, signs suggest it is slowing. The Fed’s Beige Book – a report on economic conditions across the 12 Federal Reserve Districts – reveals that 8 of 12 regions are experiencing slight economic decline or stagnation. Specifically, the factors supporting the U.S. economy in 2023—lower interest rate sensitivity, more generous fiscal support, and robust consumer spending—will not be driving forces in 2024.
The Canadian economy is likely to experience a short and shallow recession in the first half of 2024. We expect consumption and residential investment to fall as the burden of renewing mortgages at higher rates affects a number of households.
Fiscal stimulus helped offset the impact of the interest rate increases that began in March 2022. This has been felt in the housing market and in most related consumer durable purchases. Auto purchases performed better than expected as supply disruptions triggered a backlog of orders, higher prices, and limited inventory discounting. However, we anticipate a softening in retail and wholesale trade in 2024.
Discretionary spending on travel, hospitality and entertainment slowed through 2023 and we expect this trend will continue as households manage their budgets to cope with higher mortgage payments. Excess supply in the office sector, combined with concerns around interest rates, input costs, and labor shortages, will likely restrain non-residential construction this year.
Household indebtedness remains a key risk in 2024. Despite notable improvements during the pandemic, the ratio of households’ debt to disposable income is close to its highest levels at 181.6%. Last year, as interest rates went up, the debt-to-service ratio, which measures the proportion of household disposable income required to meet debt obligations, increased from 15.1% to 15.2% in the third quarter of 2023. However, even with the elevated level of debt, obligated principal payments remained relatively unchanged in the quarter. This stability is likely a result of households consolidating their debt through actions like refinancing mortgages and extending the amortization period of their loans.
Although households appear to be managing the rise in interest payments, it does pose challenges to both economic growth and the recovery in the housing market. We expect that the Bank of Canada will start cutting interest rates this year – as early as the end of Q2. Affordability is as bad as it was in 1982 when interest rates were at 14%. To get some normalization in the market, we would need to see mortgage rates drop by around 150 basis points. While this is possible over the next two years, it is highly unlikely to happen in 2024.
Housing market outlook
Overall, we believe the Canadian housing market will see an upswing in 2024. Notable improvements occurred last spring when the Bank temporarily halted rate increases (refer to the technical note below) and later in December when domestic bond rates and mortgage rates decreased following the Federal Reserve’s policy shift. While the spring market may stabilize prices, we expect mid-2024 rate cuts to boost the economy and stimulate improved home sales. However, challenges in affordability will persist, particularly in markets like BC and Ontario, and temper any material gains.
Immigration will continue to be a key factor in the coming year. Over the 12-month period ending October 1, 2023, Canada experienced its fastest population growth since the 1950s, increasing by 1.25 million or 3.2%. This surge was fueled almost entirely by international migration, with temporary workers and students accounting for most of it. Canada surpassed 800,000 international students in 2022; by the end of 2023, there were more than a million study permit holders in Canada, with more than half in Ontario.
This level of non-permanent residents contributes to the affordability challenge in the rental market, despite federal funding initiatives. Housing Accelerator Fund projects are years away from providing any relief. The government’s immediate solution involves a two-year cap on international student visas. As a result of the cap, 364,000 approved study permits are expected in 2024, a 35% decrease from 2023. The cap for 2025, which will be announced later in the year, will be allocated across the provinces based on population. Ontario is expected to see intake cut in half. Despite the reduction, this increase in population acts as a stabilizing factor in the housing market, establishing a floor to price declines, particularly in major urban areas with secondary educational institutions.
Shelter costs, a major driver of inflation, have led National Bank to argue that Canada may be in a population trap, a situation where living standards are hindered due to an insufficient economic capacity to absorb the growing population. Increasing interest rates won’t resolve the housing shortage. The key question is: when will the Bank of Canada determine that other inflationary pressures have eased sufficiently for them to disregard shelter costs?
Labour market outlook
The labour market has started to rebalance. The pace of hiring has slowed and job vacancies have declined, which should lessen the pressure on wages. The food and hospitality sector is facing the most significant labor shortages. If consumers continue to adjust their discretionary spending and restaurant owners find it challenging to meet CERB repayments, then we would expect this labor gap to close quickly in the first half of the year.
Despite immigration levels remaining high, and employment staying relatively stable, the unemployment rate should continue to climb. This will alleviate wage pressures, which is likely to reduce pricing pressures from businesses. This should create enough of an output gap that the Bank of Canada will start lowering rates.
However, external factors could exert upward pressure on prices. Geopolitical challenges persist, impacting the economic outlook. Support for Ukraine from the West has diminished as the war enters its third year. The Israel-Hamas war could spiral into a wider conflict, and disruptions in maritime trade are occurring. Political issues surrounding Taiwan and immigration in Europe may contribute to heightened economic and financial market uncertainty. These events will likely have implications for global commodity markets.
In October, the Bank of Canada expressed surprise that home prices did not drop as much as anticipated, considering the extent of monetary tightening. On top of the general supply shortage creating a floor price for housing, the asymmetric response of monetary policy to housing also plays a role. According to a 2017 working paper by Norges Bank, expansionary monetary policy shocks have a larger impact on house prices when supply elasticities are low. In regions with inelastic supply (i.e. supply does not change much when the price changes), expansionary shocks have a greater impact than contractionary shocks. Not surprisingly, we have seen this pattern in inelastic markets like Toronto and Vancouver.
Housing Affordability Watch
CMI monitors the latest developments and offers insights on solutions to Canada’s housing affordability crisis
High land costs are a significant obstacle to affordable housing development. Remediation of brownfield properties – vacant or underutilized sites with potential environmental contamination – stands out as a solution to this challenge and offers a significant opportunity for creating affordable multifamily housing in urban areas. However, despite previous attempts to promote brownfield redevelopments, obstacles such as cleanup costs, exposure to liability and financing difficulties persist.
The Canada Mortgage and Housing Corporation (CMHC) could play a pivotal role in addressing these challenges by offering innovative insurance and financial products. This includes cleanup cost cap coverage to shield developers from overruns, pollution liability protection for ongoing environmental conditions, and a Secured Creditor Policy to guarantee loan repayment in case of default or material decline in collateral value.
The latest instalment in our Housing Affordability Watch explores how CMHC’s involvement can facilitate the timely remediation and redevelopment of brownfield sites and drive positive change in the affordable housing landscape.
Read the full article for a deeper look at this innovative housing strategy: How CMHC Can Support Affordable Housing
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