The Bank of Canada cut its policy rate by 25 basis points as expected, but the focus of its commentary had less to do with its current assessment of the Canadian economy and much more on how to navigate an economy that potentially gets significantly knocked off course by U.S. tariffs.
The BoC had a good understanding (and confidence in) how the economy is currently travelling. With 200 bps of easing already in the pipeline, Canadian growth is low but slowly improving, the unemployment rate is near a peak, and inflation is now well within the BoC’s target range. We agree. Without any shocks, the central bank would likely continue to gradually ease towards, we think, 2% by year end, but in smaller magnitudes and at a slower pace than in 2024.
But, the BoC isn’t facing standard run-of-the-mill uncertainty in its outlook. Both the Monetary Policy Report and Governor Tiff Macklem’s communication took a very different tone this time around. 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.
Indeed, the BoC is fighting two particular demons that make its base case forecasts and current assessment of the state of affairs far less useful than usual. Instead, the value of their communication is in the clues they drop about how they might navigate the shocks ahead. We think most signs continue to point to further declines in interest rates, the magnitude and speed of which will be determined by the details of a potential U.S.-Canada trade conflict.
1. The BoC is facing “more than unusual uncertainty.”
It mentions “uncertainty” 42 times in the report, and, even before launching into the MPR, the BoC states its economic outlook doesn’t include any specific U.S. tariff policies yet. Governor Macklem says that we are simply missing too many pieces of information to know exactly what a trade war means for Canada.
“There’s a lot of things we don’t know, when and for how long,” he says. “We don’t know what retaliatory measure… or fiscal measures will be taken in advance”.
As we highlighted in our A playbook for how to measure a tariff shock in Canada, those details can be very significant on the direction and size of the impact in Canada.
However, the forecasts recognize that tariff threats are already impacting financial markets and business decisions. We’ve also been highlighting that tariff threats creates a negative “uncertainty” shock that weighs on growth. Downward revisions to the BoC’s forecasts for growth in 2025 and 2026 to 1.8% reflects some of this.
Moreover, Governor Macklem noted tariff threats alone “weighed on our decision” and that the more the BoC could get the economy on “solid footing” ahead of the shock, the better. We think the mere possibility of tariffs will keep the BoC on a dovish bias as it tries to prepare Canada for a potential shock. Unlike a provincial or federal government, the BoC doesn’t have to keep any “powder dry” for what’s ahead. The central bank has the luxury of preparing the economy with this cut, and, we expect, future cuts as inflation is now comfortably below 2% for three of the past four months. Put differently, the risks of excess easing are quite low in Canada, especially relative to the U.S.
2. The BoC is challenged by the complexity of modelling a tariff shock on Canada and the central bank’s role in it.
Similarly to how RBC Economics described the transmission of a tariff shock in Canada, the BoC engages in an illustrative example that highlights the challenges of measuring how badly a tariff would hurt an economy and how many assumptions would need to go into the forecast. Policymakers appear to have avoided the idea that a single number can neatly summarize the risks ahead. Governor Macklem adds that the central bank is busy running scenarios and engaging in outreach with Canadians.
Still, how the BoC would respond in a prolonged trade conflict isn’t clear. Governor Macklem said it would depend on what ended up dominating the economy once tariffs arrived—the downsides on growth or the upsides of inflation. However, there were some important takeaways about how the BoC may be thinking about its role:
- A tariff shock is a negative growth shock, but also increases inflation. It is, effectively, a “stagflationary” shock. The BoC noted it is “equally concerned about inflation rising above the 2% target or falling below it,” and there is both upside and downside risks surrounding the outlook. Our take is the BoC should focus on the downside risks around growth versus a supply-driven inflation shock (e.g. if the unemployment rate is rising, then even an inflation-targeting central bank would have to concede that rate hikes would do little to solve for inflation driven by tariffs except to create deflation in other areas of the economy). But, the BoC doesn’t appear to be determined on where it would land. That’s likely why it removed more explicit forward guidance from its statement (even as a dovish bias is clearly still in play).
- And yet, Governor Macklem emphasized that solving the damage to Canada’s economy couldn’t just be the bank’s job.
“Monetary policy cannot offset the economic consequences of a protracted trade conflict. The reality is the economy is going to work less efficiently, Canada’s going to produce less and going to earn less. Monetary policy cannot change that, it cannot offset it. It can help the economy adjust to that, a source of stability through that adjustment so that the adjustment is less unpleasant.”
(That reads like a call for fiscal policy to also help support the shock, though, of course, the BoC cannot opine directly on this topic). It also is another nod to the challenges of a stagflationary shock for a central bank, where the best course of action will remain murky even as details of a trade conflict materialize.
