Canada's economy kicked off the year stronger than many expected but that doesn't mean a downturn isn't in the cards in the coming months, according to an RBC Economics report.
"Economic growth has been more resilient than feared in the wake of aggressive interest rate increases last year," the report's authors, led by RBC chief economist Craig Wright, said.
"Still, interest rates impact the economy with substantial lags – and often end up having unintended consequences."
The most likely scenario is still that the U.S. and Canadian economies will both enter mild recessions over the middle-quarters of 2023RBC Economics
The effect of higher borrowing costs has been on full display in rate-sensitive sectors like real estate, but it has yet to fully weigh on consumer spending.
Additionally, the tight job market, China's easing of tough pandemic restrictions and strong growth in the U.S. economy have helped boost Canadian growth.
The Bank of Canada has paused its rate hikes for now, but the longer rates stay high, the more "pain to come," the report says.
"Higher interest rates will continue to cut into household purchasing power with a lag. Housing markets have continued to retrench, both in Canada and abroad. The global manufacturing outlook has softened, and easing supply chain disruptions and lower (albeit still-high) commodity prices are helping to slow inflation," it said.
"Against that backdrop, the most likely scenario is still that the U.S. and Canadian economies will both enter mild recessions over the middle-quarters of 2023."
RBC also points out Canadians will feel less wealthy as home prices fall and higher debt payments eat into disposable income, leading them to rein in spending later this year.
Road ahead likely bumpy
The type of economic landing Canada experiences will depend on how sticky inflation is and how much the central bank needs to ratchet up its fight to bring inflation down from here on in, the report says.
In January, Canadian inflation eased to 5.9 per cent year-over-year, but it's still roughly three times the Bank of Canada's target.
RBC's base case expectation is for a "mild" downturn, but says there's a chance household spending and the labour market remaining resilient in the near term, resulting in the potential for more rate hikes.
"And the alternative to the relatively mild 'bumpy' economic downturn we expect in 2023 could still look more like a crash landing down the road if substantially higher interest rates, and a larger pullback in economic activity, are required to get inflation fully back under control," the report said.
Recovery in late-2023
Beyond mid-year weakness, the anticipated surge in population as the federal government ramps up immigration could push the economy back into growth mode, RBC says.
"An immigration-fuelled surge in population growth in the wake of pandemic lockdowns will help fill some current gaps in labour markets and will add almost a million consumers to the Canadian population over 2023 and 2024," the report said.
"That boost to the production (and consumption) potential of the economy and will help put a floor under economic growth with GDP growth to resume positive, but modest, growth."
Michelle Zadikian is a senior reporter at Yahoo Finance Canada. Follow her on Twitter @m_zadikian.