Don’t Expect Miracles from Rate Cuts

Many are pinning their hopes for Canada’s economic outlook on the recently initiated rate-cutting cycle. With the Bank of Canada lowering interest rates twice already this year and signalling more cuts to come, it’s only natural to expect the Canadian economy to start coming to life. But a look at the consumer credit cycle should give us pause.

Household lending conditions have been tightening steadily for over a year. According to the Bank of Canada’s latest Senior Loan Officer Survey, financial institutions started tightening their non-mortgage lending conditions in Q4 2022 and continued making lending criteria more strict in four of the last five quarters in the survey. This manifests not only in borrowing costs that have gone up, but also in non-price lending conditions, which have tightened over the past six quarters (graph 1). We’ve never seen such a long tightening streak outside the pandemic.

The underlying reasons behind this tightening suggest it won’t end anytime soon. Lenders are reporting an increase in delinquencies. According to Equifax, the number of consumers who were delinquent on at least one credit payment in the first quarter was up 12.2% year-over-year. Meanwhile average credit scores are falling, especially for tenants, who are facing significant rent increases. And the share of credit card holders paying their monthly balance in full is down from last year. There’s been a lot of talk about the payment shock for mortgage borrowers, but we tend to forget that consumers who suddenly carry a credit card balance now face exorbitant interest charges, raising the risk of default. In response to these trends, lenders are tightening their lending requirements on new loans to manage their overall loan portfolio risk. This is a common phenomenon and reflects the interplay between the credit and economic cycles.

Household fundamentals will only make lenders more conservative going forward. By its very nature, the labour market plays a key role in lending decisions, and employment has fallen for two straight months in Canada. Meanwhile unemployment is up 1.6 percentage points from its low. It held steady in July, but only because the labour force participation rate declined, suggesting that some job seekers are discouraged. Statistics Canada’s broader measure of underemployment, which includes individuals who aren’t working because they’re discouraged, has been rising faster than the unemployment rate since early 2023 (graph 2). It remains to be seen how much lenders will differentiate between higher unemployment due to job losses, like we see during recessions, and higher unemployment due to a rapidly expanding workforce, like we’re seeing now. This is why incomes are not currently collapsing. But weak growth in inflation-adjusted disposable income over the past three years (0.9% per year on average) is still worrying.

Much of the excitement around lower interest rates rests on the notion that borrowing costs will fall, encouraging spending. But retail interest rates won’t necessarily come down overnight or automatically External link.. Furthermore, underlying this view is the assumption that credit will flow freely, which is rather optimistic given what we’ve already discussed. According to research by the Federal Reserve Bank of New York, it takes six quarters to see the full impact of a credit crunch on growth (graph 3).

This is a reminder of the obstacles that remain, and that it will take many rate cuts before we see a lasting impact. Household finances stretched thin by rising housing costs will likely cause financial stress for many consumers and prompt lenders to be more cautious. To what extent? It all depends on the job market. If labour market weakness continues to be concentrated largely among young people and newcomers, the impacts will be limited and lenders probably won’t severely restrict credit across the board. But if that weakness spreads to people in their prime working years (25 to 54), who are more likely to have considerable financial obligations, the effect on credit conditions could be more dramatic. However, this would be more in line with a hard landing, which isn’t our current base case scenario.

That said, the presence of these risks should give some perspective on the nine rate cuts we’re expecting from the Bank of Canada by the end of 2025.¹ It is by no means an aggressive rate path—just a return to neutral in about a year. If we start to see a more pronounced credit crunch, the Bank will have to pick up the pace of rate cuts if it wants to pull off the soft landing. This is why its recently renewed focus on job market signals makes a lot of sense.

¹ Our next Economic & Financial Outlook will be released on August 22.