Bank of Canada: A Cautious Cut Amid Uncertainty

The Bank of Canada recently released a report on deliberations that preceded the January 29th rate cut. Here is a summary:

A Domestic Economy in Transition

Canada’s economic picture is mixed. Household spending is showing signs of revival, buoyed by declining interest rates, while activity in the housing market has begun to pick up. GDP per capita turned positive in the third quarter of 2024 and is expected to strengthen further in 2025. A shadow does hang over Ontario’s housing market, where rising supply is weakening price growth. However, most sellers appear to be motivated and sales activity has ramped up, even with lower offers.

Exports offer a glimmer of hope. Energy shipments are poised to recover, though non-commodity exports continue to face headwinds in an increasingly competitive global market. Business investment, however, remains a concern. Firms are wary of heightened trade uncertainty, and some are contemplating shifting operations south of the border.

Labour market conditions remain soft. Unemployment stood at 6.7% in January, with wage growth sending mixed signals. Some indicators suggest private-sector wages are moderating, but overall earnings growth remains resilient.

Inflation, once a persistent worry, appears to be under control. Consumer prices rose by 1.8% in December, bringing the average inflation rate to roughly 2% since August. Core inflation remains slightly elevated at 2.5%, driven in large part by rising shelter costs. The Bank of Canada expects inflation to hover around 2% over the next two years, though risks remain.

Trade Tensions and Policy Dilemmas

A more pressing concern for policymakers is the looming spectre of protectionism. Potential American tariffs on Canadian exports could necessitate a fundamental reassessment of the country’s economic prospects. A prolonged trade conflict would likely shave points off GDP growth, dealing a heavier blow to Canada than to its southern neighbour, given its relatively small and open economy.

The investment climate is already suffering. Uncertainty over trade policy is discouraging firms from committing to long-term capital expenditures. Some are exploring relocation to the United States to mitigate potential disruptions.

Inflation could also be affected. Retaliatory tariffs would push up prices by increasing the cost of imports and creating supply chain bottlenecks. A weaker Canadian dollar might help boost exports but would further stoke import-driven inflationary pressures. While monetary policy can help soften short-term blows, it cannot offset the longer-term productivity losses that trade restrictions would bring.

A Strategic, but Measured, Rate Cut

Against this backdrop, the Bank of Canada opted for a 25-basis-point rate cut, lowering its policy rate to 3%. The move is designed to support economic growth while maintaining inflation within target levels.

Yet, with uncertainty swirling around global trade, the Bank has refrained from providing forward guidance on future rate cuts. Policymakers remain watchful, acutely aware that while monetary policy can offer short-term relief, it cannot fully insulate Canada from the economic risks ahead.

Our Perspective

The Bank of Canada is likely to maintain a cautious approach at its next rate announcement on March 12. With inflation hovering around the 2% target and economic activity showing signs of modest recovery, the central bank will weigh the impact of its recent 25-basis-point cut.

Persistent trade uncertainty, particularly concerning potential U.S. tariffs, remains a key downside risk that could dampen business investment and consumer confidence.

However, the Canadian federal government sent $250 cheques to most workers, and slashed GST on many goods from December to February, which should increase consumer spending. Stronger-than-expected consumer spending and a gradually improving labour market may limit the need for further easing of rates in the near term.

Given these dynamics, the Governing Council is expected to hold rates steady at 3% while signaling a data-dependent approach, keeping the door open for additional cuts should economic conditions deteriorate.

Presently, the U.S. the volatility and unpredictability of the United States trade policy are the wild card. The forecast depends on all known variables, but we never know when Canada’s largest trading partner will introduce a new variable.