Governor of the Bank of Canada Tiff Macklem participates in a news conference on the bank's interest rate announcement and release of the Monetary Policy Report, in Ottawa on Wednesday, Jan. 29.Justin Tang/The Canadian Press
The Bank of Canada cut its benchmark interest rate by a quarter of a percentage point on Wednesday and warned that the resilience of the Canadian economy would be tested if a trade war breaks out with the United States.
As widely expected, the central bank lowered its policy rate to 3 per cent from 3.25 per cent, its sixth consecutive cut. It also announced the abrupt end of quantitative tightening – a years-long push to shrink the size of its balance sheet after its early pandemic bond-buying spree.
With inflation largely under control, the bank has been easing borrowing costs since last summer, and policy makers had been expecting economic growth to pick up steam. The threat of U.S. tariffs, however, has thrown a major curveball at the Canadian economy and the central bank.
“A long-lasting and broad-based trade conflict would badly hurt economic activity in Canada. At the same time, the higher cost of imported goods will put direct upward pressure on inflation,” Bank of Canada Governor Tiff Macklem said in a press conference after the rate announcement.
U.S. President Donald Trump has threatened to put a 25-per-cent tariff on all Canadian imports as early as this Saturday. He has also tasked his administration with developing a range of other protectionist trade measures by April 1.
Mr. Macklem said the extraordinary threat of tariffs “weighed on” the bank’s decision to cut interest rates again. Central banks don’t typically change monetary policy in anticipation of political promises that haven’t been enacted. But Mr. Macklem justified the move as an exercise in risk management.
“The more we can get the economy on a solid footing before it faces new tariffs, the better,” he said.
In an unusual coincidence, the U.S. Federal Reserve also delivered a rate decision on Wednesday. In stark contrast to its northern counterpart, the Fed kept the target range for its benchmark rate steady at 4.25 per cent to 4.5 per cent, and signalled that it’s entered a holding pattern after a series of cuts.
The Fed is dealing with stronger economic growth and stickier inflation than the Bank of Canada. It’s also grappling with a policy agenda from the new Trump administration – which includes tariffs, tax cuts and migrant deportations – that many economists see as inflationary.
In a press conference after the announcement, Fed chair Jerome Powell batted aside questions about Mr. Trump’s policies, and focused instead on uncertainty that comes from any new administration.
“The range of possibilities is very very wide,” he said of tariffs. “We don’t know what’s going to be tariffed. We don’t know for how long, or how much, what countries. We don’t know about retaliation. ... So we’re just going to have to wait and see.”
The Bank of Canada decided not to incorporate tariffs into its latest forecast, published Wednesday. However, it did publish several scenarios in its quarterly Monetary Policy Report (MPR) estimating the potential impact of a major trade war.
According to the “benchmark” scenario, if the United States imposes 25-per-cent tariffs on all imports, and its trading partners retaliate in kind, Canadian GDP growth would be 2.4 percentage points lower in the first year, and 1.5 percentage points lower in the second year. Meanwhile, inflation would be 0.1 percentage points higher in the first year and 0.5 percentage points higher in the second year.
Alternative scenarios, based on different assumptions about how households and businesses might respond to a 25-per-cent tariff, suggested GDP growth could be as much as three percentage points lower in the first year, and inflation could be as much as 0.8 percentage points higher.
“If central banks use the idea that setting monetary policy in uncertain times is like walking around in a dark room and trying not to trip on furniture, the BoC could more appropriately be described as blindfolded with projectiles being thrown at it,” Frances Donald, chief economist at Royal Bank of Canada, wrote in a note to clients.
The Bank of Canada’s scenarios aren’t forecasts. But they highlight why trade wars are complex for central banks – which really have only one policy lever – to manage. Tariffs dampen growth and kill jobs, potentially requiring lower rates to stimulate the economy through a recession. At the same time, countertariffs and currency depreciation push up import prices, suggesting higher interest rates might be needed to head off inflation. In other words, tariffs are a “stagflation” shock that pulls central bankers in opposite directions.
“We can’t lean against lower growth and higher inflation at the same time. So we’re going to have to weigh which one’s bigger, and we also have to look at the timing – which effect is bigger in what time period,” Mr. Macklem said.
Financial markets expect the central bank to cut one or two more times this year. Traders in interest-rate swaps, which capture expectations about monetary policy, put the odds of another quarter-point cut at the next meeting on March at around 40 per cent, according to LSEG data.
Leaving aside the threat of tariffs, the bank’s latest forecast shows inflation remaining close to the bank’s 2-per-cent target over the next two years. GDP growth forecasts were downgraded slightly, largely as a result of slower population growth after the federal government’s recent immigration caps.
“If not for the tariff threat, we would be talking about the Bank moving to the sidelines today,” Bank of Montreal chief economist Douglas Porter wrote in a note to clients.
“Next steps clearly are dependent on what unfolds on the trade front. We suspect while the Bank may initially respond cautiously to a trade war, eventually it would be compelled to cut much more than the market currently expects,” he added.
Wednesday’s rate decision will lower interest rates on variable-rate mortgages and could add to momentum to Canada’s real estate market. Home sales have picked up in recent months as lower interest rates have brought buyers back into the market.
“This latest decrease arrives just before the spring housing market – when demand typically picks up – which should spur buying and selling activity in the weeks ahead,” Phil Soper, president and chief executive officer of Royal LePage, said in a statement. Although he noted that a trade war “could eventually cause activity to slow.”
Canadian bond yields declined after the rate announcement, and the Canadian dollar weakened slightly against the U.S. dollar.
The loonie is trading near a four-year low, hovering between 69 and 70 US cents. The weak exchange rate is partly the result of the growing divergence between U.S. and Canadian interest rates, the Bank of Canada said in its MPR, although the threat of a trade war is likely playing a larger role.
“There’s no doubt the exchange rate is responding to the threat of tariffs,” Mr. Macklem said. “Obviously the bigger the movements in the Canadian dollar, the more we’re going to have to take those into account as we set policy going forward.”
The Bank of Canada’s intention to end quantitative tightening was signalled in a speech earlier this month, although the timeline the bank outlined on Wednesday is faster than many market participants expected. The bank has been shrinking the size of its balance sheet over the past two years by letting the billions of dollars worth of bonds it purchased during the COVID-19 pandemic mature without replacing them.
The bank said it will now start purchasing financial assets again starting in early March, with the goal of stabilizing the size of its balance sheet and letting it grow “modestly” in line with the economy.