Bank of Canada's Rate Cut and the Looming Tariff Threat

The Bank of Canada today announced a significant move, reducing its target for the overnight rate to 3%, with the Bank Rate at 3.25% and the deposit rate at 2.95%. This decision comes amidst considerable uncertainty surrounding the potential imposition of new tariffs by the United States. The central bank is also announcing its plan to complete the normalization of its balance sheet, ending quantitative tightening. Beginning in early March, the Bank will restart asset purchases, starting gradually to stabilize and then modestly grow its balance sheet in line with economic growth.

Impact of Past Interest Rate Cuts and Economic Growth

Past cuts to interest rates have already begun to stimulate the Canadian economy, with recent strengthening in both consumption and housing activity expected to continue. However, business investment remains weak. The outlook for exports is somewhat buoyed by new export capacity for oil and gas. Despite this positive development, economic growth is forecast to strengthen further in the absence of new tariffs, with inflation remaining close to 2%. However, the threat of new tariffs introduces substantial uncertainty. The Bank projects GDP growth of 1.8% in both 2025 and 2026, which is slightly higher than potential growth, leading to a gradual absorption of excess supply in the economy.

Canada's Labour Market and Inflation

Canada's labour market, while still soft with an unemployment rate of 6.7% in December, has shown signs of improvement with strengthened job growth in recent months. Wage pressures, previously persistent, are exhibiting signs of easing. CPI inflation remains near the 2% target, though volatility exists due to the temporary suspension of the GST/HST on certain consumer products. Shelter price inflation, while elevated, is gradually easing as anticipated, with various indicators suggesting underlying inflation is also close to 2%. The Bank forecasts CPI inflation to remain around the 2% target for the next two years.

Monetary Policy Decision and Uncertainty

With inflation at approximately 2% and the economy operating with excess supply, the Governing Council opted for a further 25 basis point reduction in the policy rate. This cumulative reduction since last June is considerable, and lower interest rates are expected to provide a boost to household spending, thus strengthening the economy gradually and maintaining inflation near its target. The current forecasts remain somewhat clouded by the uncertainty caused by the threat of US tariffs. This decision is further explained by Governor Tiff Macklem's statement, highlighting that "Lower interest rates are boosting household spending and, in the outlook published today, the economy is expected to strengthen gradually and inflation to stay close to target."

The Threat of US Tariffs: A Potential Economic Storm

The Bank of Canada’s Monetary Policy Report (MPR) acknowledges the significant uncertainty introduced by the potential imposition of US tariffs. The report provides a baseline forecast that assumes the absence of new tariffs. The MPR acknowledges that a protracted trade conflict could severely impact the Canadian economy leading to weaker GDP and higher inflation. The Bank's baseline forecast does not include tariffs, projecting 1.8% growth in real gross domestic product for both 2025 and 2026. However, a “severe” scenario involving broad-based tariffs of 25% imposed by the US and reciprocated by Canada could cause a significant downturn, including pushing the economy into a recession and increasing inflation. In this hypothetical situation, Canadian GDP would be 2.5 percentage points lower in the first year. This severe scenario was carefully analyzed by the Bank of Canada, with Macklem noting that it would significantly hurt economic activity while increasing prices. The lack of clear historical precedence for tariffs of this scale adds to the forecasting difficulty, while the impacts on various sectors, the potential for retaliatory tariffs, and exchange rate fluctuations all introduce even more complexities.

Navigating the Uncertain Waters: The Bank of Canada's Response

Governor Macklem emphasized that monetary policy alone cannot fully counteract the economic effects of a prolonged trade conflict. He explained that while the Bank of Canada is committed to maintaining price stability, the central bank's capacity to manage the economy while battling both higher inflation and a possible recession is limited. While the Bank of Canada aims to help the economy adapt to new developments, the inherent uncertainty surrounding the trade conflict with the United States makes precise economic impact projections challenging. They expect to closely follow and assess developments to determine the appropriate course of action for monetary policy. Macklem's emphasis that "Monetary policy cannot offset the economic consequences of a protracted trade conflict" reflects the inherent limitations in using interest rate adjustments to fully neutralize large external economic shocks.

Looking Ahead: The Path of Monetary Policy

The next announcement regarding the overnight rate target is scheduled for March 12, 2025, with the next comprehensive economic and inflation outlook to be released in the MPR on April 16, 2025. The Bank of Canada's plan to complete its balance sheet normalization, ending quantitative tightening, is a key element of their approach to managing the financial landscape, even amidst uncertainty. The decision to restart asset purchases reflects their intention to take proactive steps to help maintain economic stability. The Canadian government, and indeed other economic actors, are fully aware of the challenges ahead and are closely monitoring these developments.

A Cautious Approach in a Stormy Climate

The Bank of Canada’s actions are generally seen as a cautious approach to a potentially perilous situation. The interest rate cut is a response to economic softening. While the Bank of Canada is prepared to implement further cuts if needed, the focus remains on navigating the uncertainty brought on by the potential tariff dispute. This strategic maneuver highlights the need for flexibility and adaptability in the face of unpredictable external factors that significantly impact a nation’s economy.