The Bank of Canada held its policy interest rate steady for the third consecutive time Wednesday, but left the door open to additional rate cuts if U.S. tariffs weaken the Canadian economy and inflation remains under control.
As widely anticipated, the central bank’s governing council voted to keep the benchmark interest rate at 2.75 per cent, where it has been since March.
Governor Tiff Macklem said the Canadian economy has weathered U.S. President Donald Trump’s trade war better than expected, and that there was a “clear consensus” among governing council members to keep monetary policy on hold.
However, he also struck a dovish note, suggesting recent hot inflation readings should fade over time and that more interest rate cuts could be on the agenda this fall.
“If a weakening economy puts further downward pressure on inflation and the upward price pressures from the trade disruptions are contained, there may be a need for a reduction in the policy interest rate,” Mr. Macklem said in a press conference after the rate announcement.
Signs of resilience in the Canadian economy were enough for the Bank of Canada to leave its benchmark interest rate unchanged at 2.75 per cent.
The Canadian Press
The U.S. Federal Reserve followed suit a few hours later, keeping its policy rate in the 4.25 per cent to 4.5 per cent range, where it has been since December.
In remarks after the rate announcement, Fed Chair Jerome Powell sounded more hawkish than his northern counterpart. He highlighted the strength of the U.S. economy and the fact that inflation remains above the Fed’s target – seeming to push back against market expectations that rate cuts will resume in September.
“The labour market is actually still quite solid. Inflation is above target, even ignoring tariffs,” Mr. Powell said in a press conference. “We’re watching all of that, and trying to do the right thing in what is a challenging situation, because you’re being pulled in two directions.”
Both central banks are navigating massive uncertainty created by Mr. Trump’s barrage of tariffs and attempt to rewrite the rules of global trade.
The President has increased trade duties to the highest level since the 1930s and left other countries scrambling to maintain access to the world’s largest consumer market. Mr. Trump set a Friday deadline for some sort of trade deal with Canada, although he has thrown doubt on whether it will happen.
The series of agreements the President signed with Japan, the European Union and other countries in recent weeks have “reduced the risk of a severe and escalating global trade war,” Mr. Macklem said.
“Unfortunately, the tariffs in those agreements also suggest the United States is not returning to open trade,” he added.
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As in April, the Bank of Canada responded to the uncertainty by foregoing a central forecast in its quarterly Monetary Policy Report.
Instead, it outlined three potential scenarios for inflation and economic growth that depend on the trajectory of Mr. Trump’s global trade war and Ottawa’s continuing negotiations with Washington.
The “current tariff scenario” outlined in the report assumes existing U.S. levies on steel, aluminum and automobiles, as well as on goods that don’t meet the United States-Mexico-Canada agreement’s rules of origin, remain in place – but don’t get worse.
In that scenario, the bank sees the Canadian economy contracting in the second quarter, before expanding by around 1 per cent in the second half of the year, thereby avoiding an outright recession. Inflation, in this projection, stays around the bank’s 2-per-cent target.
In the “de-escalation scenario” in which Prime Minister Mark Carney is able to secure some tariff relief, economic growth picks up and there is less upward pressure on consumer prices from either tariffs or supply chain disruptions.
In the “escalation scenario,” in which Canada is hit by new sectoral tariffs and loses its USMCA tariff exemption, the economy enters a recession, with three quarters of negative growth, while inflation picks up.
“The lack of a conventional forecast does not impede our ability to take monetary policy decisions,” Mr. Macklem said.
“But the unusual degree of uncertainty does mean we have to put more weight on the risks, look over a shorter horizon than usual, and be ready to respond to new information.”
Financial markets raised their bets on a quarter-point rate cut at the next BoC decision on Sept. 17, after the Wednesday announcement. However, interest rate swap markets, which capture expectations of about monetary policy, still only put the odds of a September cut at around 15 per cent, according to LSEG data.
“The Bank appears to be getting a little more comfortable with the notion that the Canadian economy will need support from further interest rate cuts in the future,” Canadian Imperial Bank of Commerce economists Andrew Grantham and Katherine Judge wrote in a note to clients.
“However, it is clearly not there yet and upcoming data will remain more important than today’s slight change in language in determining if that support comes as early as the September meeting as we currently forecast.”
Trade wars are a particularly tough type of shock for central bankers to manage. Tariffs and other trade disruptions tend to increase costs for businesses that are eventually passed along to customers, boosting inflation. But they also disrupt normal economic activity and increase unemployment, which puts downward pressure on inflation over time.
Without a clear sense of where things are heading, central bankers – whose mandate is to maintain price stability – are left scouring the data to see which way inflation and other economic indicators break.
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Inflation is running slightly hot in Canada. Annual consumer price index inflation came in at 1.9 per cent in June, but that number was lowered by the one-off cancellation of the consumer carbon price in the spring. Excluding taxes, inflation was 2.5 per cent while core inflation measures were around 3 per cent.
Mr. Macklem did not sound particularly concerned about this. “Boiling it all down, there are reasons to think that the recent increase in underlying inflation will gradually unwind,” he said, noting the appreciation of the Canadian dollar exchange rate, which makes imports cheaper, as well as slowing wage growth.
Meanwhile, the Canadian economy has been more resilient than many people expected earlier in the year. Some of this has to do with a surge in exports to the U.S. in the first quarter, as companies rushed goods across the border to get ahead of the levies.
Tariffs have also bitten less than feared, thanks to the carve-out for USMCA-compliant goods, which has allowed the vast majority of Canadian exports – outside of the aluminum, steel and auto industries – to continue to trade tariff-free.
Despite Mr. Trump’s double-digit tariff threats, the Bank of Canada estimates that the current effective U.S. tariff rate on Canadian goods is around 5 per cent, up from effectively zero at the start of the year.
Still, the economic outlook remains fairly grim. The bank expects GDP to contract 1.5 per cent in the second quarter, as the surge in exports in the first quarter goes into reverse.
Unemployment is elevated, particularly in the sectors affected by tariffs, and Canadian consumers and businesses are holding back on spending, the bank said. All of this could get much worse if Mr. Trump doubles down on his tariff strategy.
Even in the bank’s more optimistic scenario, Canada’s economy will be permanently scarred by the trade war.
“The sad reality is that tariffs mean the economy is going to work less efficiently. It means there’s going to be less income, so there’s going to be less consumption,” Mr. Macklem said. “The economy will resume growing, but it will be on a permanently lower path” unless the tariffs are removed.