The Bank of Canada warned after delivering another interest rate cut on Wednesday that Canada’s economy would be “tested” if the United States delivers on a threat to impose blanket tariffs on Canadian goods.
In a “severe” scenario mapped out by the central bank, those tariffs could simultaneously send the Canadian economy into a recession later this year and push inflation higher.
The Bank of Canada on Wednesday cut its benchmark interest rate by 25 basis points, bringing the policy rate down to 3.0 per cent.
The move — the central bank’s sixth cut in a row — was widely expected by markets and most economists.
BMO chief economist Doug Porter said in a note to clients on Wednesday that the quarter-point drop solidifies the Bank of Canada’s position as the “most aggressive cutter in the world.”
Wednesday’s statements contained little forward guidance from the central bank about where interest rates could be heading next.
“There’s a lot of uncertainty out there and it just didn’t seem useful to provide guidance,” Bank of Canada governor Tiff Macklem told reporters on Wednesday.
Trump tariff threats loom over policy rate
The Bank of Canada’s focus on Wednesday revolved largely around the threat of tariffs from the United States and the impact of a looming trade dispute.
As of Wednesday, U.S. President Donald Trump has maintained that he is weighing imposing 25 per cent blanket tariffs on goods from Canada and Mexico on Feb. 1.
“The potential for a trade conflict triggered by new U.S. tariffs on Canadian exports is a major uncertainty. This could be very disruptive to the Canadian economy and is clouding the economic outlook,” Macklem said on Wednesday.
The central bank warned in a statement accompanying the rate cut that, “if broad-based and significant tariffs were imposed, the resilience of Canada’s economy would be tested.”
James Orlando, director of economics at TD Bank, told Global News that Canada was gearing up for a “banner year” economically with inflation largely under control and previous interest rate cuts setting up growth.
“(This) was supposed to be a year of economic revival in Canada,” he said. “And now with Trump, that’s all uncertain.”
Macklem said that it’s unclear exactly how Canada’s economy would respond to tariffs, because policymakers don’t know how steep the restrictions would be, what they would cover and how long they would be in place. How Canada would respond is also a wild card in the forecast.
“Nevertheless, some things are clear,” Macklem said.
“A long-lasting and broad-based trade conflict would badly hurt economic activity in Canada. At the same time, the higher cost of imported goods will put direct upward pressure on inflation.”
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The Bank of Canada is not including tariffs in its baseline forecasts for the economy. A revised outlook released Wednesday calls for 1.8 per cent growth in real gross domestic product over both 2025 and 2026.
But the central bank did conduct an analysis of one scenario, which Macklem called a “severe” case, wherein the U.S. applies blanket tariffs of 25 per cent on all trade partners — not just Canada and Mexico — and those nations impose matching tariffs in kind. This situation would also see those tariffs remain in place on a “permanent” basis, not waived quickly as a negotiation tactic.
Under this analysis, Canada’s real GDP would be about 2.5 percentage points lower than it would be in the first year of tariffs than it would be otherwise. That would put Canadian economic growth into recession territory for this year — a forecast backed up by other economists who have weighed the impact of possible U.S. tariffs.
Inflation could also jump higher, at least on a temporary basis, the Bank of Canada projects. Whether those cost hikes are temporary or sustained depends on whether inflation expectations also rise, a phenomenon that helped keep price pressure sticky in the recovery from the COVID-19 pandemic.
A trade war could impact prices in a few ways, but the central bank is quick to point out that there’s little historical precedent for tariffs of this magnitude.
If Canada were to impose retaliatory tariffs on American goods in response to U.S. trade salvos, those items would become immediately more expensive for Canadian businesses.
Trade uncertainty has also been a significant drag on the exchange rate between the Canadian and U.S. dollars since Trump’s re-election, and a weaker loonie makes imports more expensive.
Macklem said Wednesday that this could drive up inflation on fresh fruit and vegetables at a time of year when much of the produce Canadians buy from the grocery store is imported from abroad.
“That’ll get passed through pretty quickly,” Macklem said of higher costs on produce.
A wider differential between interest rates on either side of the Canada-U.S. border can also hurt the loonie.
The U.S. Federal Reserve pressed pause on its interest rate cut cycle on Wednesday as it, too, waited to gauge the inflation implications from Trump’s policies.
The Canadian dollar weakened somewhat against the American greenback on Wednesday and remains more than six per cent lower year-over-year, holding above 69 cents US.
How can the Bank of Canada respond to a trade war?
Macklem said that with inflation back around the central bank’s two per cent target — it cooled to 1.8 per cent in December — monetary policy “is better positioned to help the economy adjust to new developments.”
But he also acknowledged that the Bank of Canada’s only tool to respond to trade uncertainty is the benchmark interest rate, which can be limited in the face of both a weakening economy and rising inflation. Lower rates stimulate economic growth, while higher borrowing costs are meant to tame inflation.
“We can’t lean against weaker output and higher inflation at the same time,” Macklem said, adding that the governing council would need to “carefully assess” the inflation forecast amid a weakening economy.
Orlando said that, in TD’s modelling, tariffs are expected to lift up inflation after they’re imposed but have the opposite effect when they’re removed. For the economy, however, trade wars have a more prolonged, negative effect as consumer spending and business confidence take a hit.
That should push the Bank of Canada to lean more towards reducing interest rates to shore up the economy, rather than raising them or keeping them elevated to deal with inflation risks, Orlando said.
“In the end, the GDP shock probably outweighs the inflation shock, should this prove to be temporary,” he said.
Wednesday’s interest rate decision shows a central bank gearing up for the worst but not yet sounding the alarm, economists say.
“Today’s steps by the Bank of Canada can be viewed as battening down the hatches ahead of a possible trade war storm,” Porter said in his note.
Porter disagrees that inflationary impacts would be as pronounced as in the Bank of Canada’s projections, but he said that the communications from the central bank on Wednesday show monetary policymakers will proceed cautiously in the event of a Canada-U.S. trade dispute.
Money markets see a more than 43 per cent chance of another quarter-point cut at the Bank of Canada’s next rate decision on March 12, according to Reuters.
But if tariffs are imposed and prove to have staying power, eventually the Bank of Canada “would be compelled to cut much more than the market currently expects,” Porter said.
Orlando said Wednesday that, absent a trade war, he is maintaining a call for 75 basis points of further interest rate cuts this year to bring the Bank of Canada’s policy rate down to 2.25 per cent. He said the Bank of Canada doesn’t necessarily need to keep cutting rates at every meeting going forward, and a pause may well be in the cards at upcoming decisions.
Macklem was asked Wednesday how he will be preparing on Saturday as Trump’s Feb. 1 tariff deadline arrives.
“I will be watching the news very closely,” he said.
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