The Canadian economy slowed more than expected in the first half of the year, a development that could strengthen the case for the Bank of Canada to hold interest rates when it convenes next week.

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Gross domestic product (GDP) contracted 0.2 per cent, annualized, in the second quarter due to drops in housing investment, slower exports and depressed household spending, Statistics Canada reported Sept. 1.

The figure is a significant deviation from the growth of 1.2 per cent and 1.5 per cent that economists and the Bank of Canada, respectively, had forecast for the quarter running from April to June.

The statistics agency also made a downward revision to GDP growth in the first quarter from 3.1 per cent, annualized, to 2.6 per cent.

GDP in June contracted 0.2 per cent while preliminary estimates for July show GDP remained unchanged. Wildfires across the country contributed to the flat reading, but weakness was widespread.

The Bank of Canada did not come off the sidelines to raise interest rates until June, meaning the central bank was on pause for the majority of the second quarter. The economy’s surprisingly weak output for the period likely means policymakers will keep the overnight interest rate at the current five per cent.

“The GDP numbers reinforce our view that the Bank of Canada is done hiking,” Desjardins economist Tiago Figueiredo said in a client note. “Yields have moved significantly lower, with markets coming around to our long-standing view that further rate hikes aren’t in the cards.”

Growth in household spending softened in the second quarter to 0.2 per cent, annualized, down from a downwardly revised 4.7 per cent in the first quarter.

Wages grew in the second quarter by 2.2 per cent, following a 1.9-per-cent increase in the previous quarter. Higher wages helped boost household disposable income, which increased 2.6 per cent in the second quarter.

Housing activity decreased by 8.2 per cent, the fifth consecutive quarterly decline, said Bank of Montreal chief economist Douglas Porter. A drop in new construction and renovation activities contributed to the decline. On the flip side, resale activity increased in the quarter, as indicated by an 18.2-per-cent increase in ownership transfer costs.

“The broad softening in the domestic economy will almost certainly move the BoC to the sidelines,” Porter said in a client note. “Between the half-point rise in the unemployment rate, the marked slowing in GDP, and some cooling in core inflation, it now looks like rate hikes are over and done.”

In June, goods-producing and services-producing industries contracted, dragged down by wholesale, retail and construction sectors.

The third quarter might experience a short-term boost due to federal government transfers, such as the grocery rebate, but growth should continue to slow, especially as the labour market weakens, said Toronto-Dominion Bank economist James Orlando.

Employment growth dropped to a three-month average pace of 12,000 in the second quarter from 80,000 in the first, Orlando said in his note.

“So much for that overheating economy,” he wrote. “Canada has entered a stage of below trend economic growth. This should continue through the rest of this year, as the impact of high interest rates works through the economy to prevent another acceleration in demand.”

• Email: bbharti@postmedia.com