Bank of Canada Governor Tiff Macklem takes part in a press conference, after announcing interest rate cuts in Ottawa, on March 12.Blair Gable/Reuters
Jeremy Kronick is vice-president and director of the Centre on Financial and Monetary Policy at the C.D. Howe Institute, where Steve Ambler, a professor of economics at Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy.
The Bank of Canada lowered its benchmark interest rate to 2.75 per cent on Wednesday, its seventh consecutive cut. Notwithstanding recent data showing a strong economy at the turn of the year, the trade war with the United States, the U.S.’s flip-flopping policy on tariffs against Canadian goods and the uncertainty they have caused sealed the deal.
Markets, businesses and consumers all crave certainty. We currently have none. A widely used economic policy uncertainty index sits today at almost twice its level in the depths of the COVID-19 pandemic and more than three times its level during the 2008 financial crisis. Unprecedented, to say the least.
Such extreme uncertainty makes incoming data hard to read and forecasting next to impossible. The Bank of Canada had to make a decision, however. And we agree with its decision to cut its benchmark rate.
Put aside the trade situation, and there might have been a case for the central bank to leave the overnight rate unchanged. Core inflation measures – which calculate the underlying trend of price changes in the economy – ticked up in January and remain stubbornly above the 2-per-cent target. Average hourly earnings are rising considerably faster than productivity. And real gross domestic product in the fourth quarter of 2024 outpaced expectations.
That said, there were plenty of data pointing the other way. The year-over-year increase in the consumer price index has been at or below target since last August. Stripping out mortgage interest costs, which go up when the overnight rate increases and vice versa, CPI inflation sits at 1.5 per cent. February’s unemployment rate of 6.6 per cent is almost two percentage points higher than its postpandemic minimum in July, 2022, and almost one percentage point above where it was before COVID hit in February, 2020.
The bank’s range for its neutral rate – the policy rate consistent with output at potential and inflation on target – is 2.25 to 3.25 per cent. Bringing the policy rate down to 2.75 puts us squarely in the middle of the range. With this conflicting data, getting to the midpoint makes sense. The uncertainty surrounding the trade conflict makes it all the more justifiable.
Where to from here? The unusual combination of supply and demand shocks will make the bank’s next interest-rate decision no less hard.
U.S.-imposed tariffs will raise prices in Canada as a depreciating loonie will make imports more expensive. If Canada retaliates with tariffs on imports from the U.S., those tariffs will raise prices further. The bank will have to decide whether these changes to the price level are one-off, or preludes to higher inflation. If the effects are one-off, the bank should concentrate on offsetting the tariffs’ negative impact on the demand side as our businesses sell less, jobs are lost and consumers reduce spending.
Canadian fiscal policy adds another complication. Finance Minister Dominic LeBlanc says the federal government can support businesses and individuals in the face of increases in U.S. tariffs. A substantial increase in government transfers would increase aggregate demand and at least partially counteract the decrease in demand for Canadian exports to the United States. But even here we have uncertainty as the government is on its way out, and incoming prime minister Mark Carney is expected to call a snap election; we don’t know who will make up the new government after we head to an election.
All this uncertainty is damaging for business investment, already very weak, as projects are temporarily or permanently shelved. This negative impact on the productive capacity of the Canadian economy makes the net effect of the uncertainty on the output gap – the difference between the economy’s actual and potential output – ambiguous. For the Bank of Canada itself, the next interest-rate announcement in April must at this point be a mystery.
The best forecasters at the central bank can do is to simulate different scenarios based on different assumptions. The Bank of Canada was wise to refrain from any forward guidance about its next moves and underline the dependence of its policy rate on the data. It was also wise this time around to cut their interest rate.