The Bank of Canada announced a 25-basis-point reduction in its key interest rate, bringing it down to 3%. This marks the sixth consecutive rate cut and a shift from the more aggressive 50-basis-point reductions implemented in the previous two decisions. Governor Tiff Macklem emphasized that this move aims to maintain price stability, achieved through previous monetary policy adjustments. He also highlighted the significant uncertainty posed by proposed U.S. tariffs, labeling them a potential major disruptor to the Canadian economy and a key factor clouding the economic outlook. The Bank’s current projections, therefore, assume a baseline scenario without tariffs, while acknowledging the potential for severe economic consequences should a trade conflict arise.
Macklem outlined three key takeaways from the announcement. Firstly, inflation has stabilized near the 2% target since last summer, indicating the effectiveness of previous monetary policy interventions. Short-term inflation expectations have normalized, and broad-based inflationary pressures have subsided. Although shelter price inflation remains elevated, it is gradually declining. The Bank anticipates inflation to remain near the 2% target over the next two years, despite potential fluctuations due to temporary tax measures. Secondly, the economy is showing signs of recovery, driven by the cumulative effect of past interest rate cuts. Lower borrowing costs are stimulating activity in the housing market and boosting consumer spending on durable goods like automobiles. This positive momentum is expected to extend to other consumer segments and further strengthen household spending. Business investment, although currently weak, is projected to gradually increase, while the export outlook benefits from expanding oil and gas export capacity.
Despite these positive developments, the labor market remains relatively soft. While employment has improved recently, job creation has lagged behind labor force growth for over a year. The unemployment rate stood at 6.7% in December, and although wage pressures have persisted, there are indications of easing. The Bank projects GDP growth to strengthen from 1.3% in 2024 to 1.8% in both 2025 and 2026. Growth in GDP per capita is also expected to rise, supported by lower interest rates and increased incomes. This overall GDP growth projection, however, is more modest than the October forecast, primarily due to lower population growth resulting from new federal immigration policies. The Bank acknowledges risks to its outlook, emphasizing its commitment to addressing both the possibility of inflation exceeding or falling short of the 2% target. In the absence of tariffs, the risks to inflation are considered balanced.
The looming threat of U.S. tariffs represents a major source of uncertainty, with numerous potential scenarios and unknown variables. The Bank acknowledges the difficulty in precisely predicting the economic impacts of these tariffs, given the lack of historical precedents for changes of this magnitude. However, it’s clear that a protracted and widespread trade conflict would severely damage the Canadian economy, while simultaneously pushing inflation upwards due to increased import costs. The extent and timing of these impacts will depend significantly on how businesses and households in both the U.S. and Canada adapt to higher import prices. The Bank emphasizes that tariffs inherently reduce economic efficiency, leading to lower production and earnings.
While monetary policy cannot fully offset the negative effects of tariffs, it can facilitate economic adjustment. With inflation currently near the target level, the Bank is well-positioned to provide economic stability. However, its single policy instrument – the interest rate – cannot simultaneously address both weaker output and higher inflation. The Bank’s response will require a careful balancing act, weighing the downward pressure on inflation from economic weakness against the upward pressure from higher input prices and supply chain disruptions. To prepare for this challenge, the Bank has been actively investing in enhanced information gathering related to supply chains, trade links, and inter-sectoral connections. This improved data analysis is aiding in assessing the potential impact of supply disruptions, including tariffs.
The Bank has initiated assessments of various tariff scenarios, including an example presented in the Monetary Policy Report. Furthermore, it’s increasing outreach activities across the country to gather firsthand perspectives from those directly affected by trade uncertainty. This includes augmenting existing business and consumer surveys to understand how trade uncertainty influences decision-making and how they might respond to a trade conflict. The Bank commits to providing updates on its analysis and assessments as the situation evolves. Having restored low inflation and significantly reduced interest rates, the Bank believes its monetary policy is now better equipped to support the economy’s adjustment to unfolding developments. It reaffirms its commitment to its monetary policy framework and its primary objective of maintaining long-term price stability.
