The economy says cut

The BofC is in a tough spot. The economy is not doing particularly well, with unemployment rising to 6.9% in June and second quarter GDP tracking slightly negative. 

The Bank’s forecast has now been downgraded significantly since January (see below), and the economy is projected to be on a permanently lower path than had tariffs not been introduced at all.

That said, the economy has demonstrated some resilience, and seems to be avoiding the outcome many feared post ‘liberation day’. 

“In Canada, US tariffs are disrupting trade but overall, the economy is showing some resilience so far.”

"A number of economic indicators suggest excess supply in the economy has increased since January.”

The inflation data says not so fast

So what’s the problem? Inflation.  

The headline inflation rate is right where it should be - 1.9% in June almost bang on the 2% target. The issue is that this is due to some temporary factors, namely a pullback in energy costs and in particular the removal of the carbon tax.  Looking beyond these deviations, trend inflation is stronger.

“CPI inflation has been pulled down by the elimination of the carbon tax and is just below 2%. However, a range of indicators suggest underlying inflation has increased from around 2% in the second half of last year to around 2½% more recently”.

However, the Bank seemed less worried (or more dovish) about inflation, expecting some of the pressures to ease. In particular, the easing of labour costs, the higher Canadian dollar (lowering import costs) and the economy in “excess supply”. Their baseline forecast is for inflation to average around 2% this year.

“Boiling it all down, there are reasons to think that the recent increase in underlying inflation will gradually unwind.” 

Murky outlook

The Bank of Canada’s job is to look forward, not stare in the rear view mirror. If they make a rate decision now, it takes months for that change to take full effect on the economy.

That said, there appears to be some reluctance by the Bank to put out a forecast. Last time, in April, they offered no forecast at all - just scenarios, citing heightened tariff uncertainty. This time around they put out a forecast, but they call it a ‘current tariff scenario’ and still ran two alternate scenarios. 

The Bank’s base scenario has the Canadian economy growing 1.3% this year, and 1.1% next year. That’s not too far off our latest June call of 1% and 1.2%, respectively.  

The current projections are clearly better than originally feared. But they’re well below their January (pre-tariff) outlook of 1.8% in both years. The Bank emphasized that the level of “GDP is on a permanently lower path owing to tariffs”. 

More interesting is that inflation looks to be cooperating in the forecast, with a 1.9% inflation in 2025 and 2.0% in 2026. 

The BofC emphasizes the tug of war (our metaphor, not theirs) between two competing inflation forces: 1) counter-tariffs add to inflation by raising the cost of imports while 2) a weak economy, along with easing shelter costs and a stronger loonie subtracts from inflation. 

Keep your eye on the data

It’s a particularly tricky time to forecast. Today’s forecasts were presented with plenty of caveats and accompanying scenarios. In the Monetary Policy Report (MPR), the word ‘uncertainty’ was used 68 times by our count. 

From the press conference: “the unusual degree of uncertainty does mean we have to put more weight on the risks, look over a shorter horizon than usual, and be ready to respond to new information”.

With such a murky outlook, the default position is to lean more heavily on the incoming data. 

Bottom line:  Expect the next two inflation reports before the September announcement to carry extra weight. An easing in underlying inflation could tip the scale towards a cut.

Interest rate plane has almost landed

This announcement does not change our view that the Bank of Canada is almost done cutting. It’s already in the ‘neutral’ range of 2.25-3.25%. Our forecast has only two more rate cuts, and today’s more dovish-than-expected comments reinforces this view. 

Macklem left the door open to further rate cuts:

“If a weakening economy puts further downward pressure on inflation and the upward price pressures from the trade disruptions are contained, there may be a need for a reduction in the policy interest rate.”   

However, he has also been clear since the outset of the trade war that he’s not coming to the rescue. This is because tariffs add to price pressures, even as the economy slows, putting the BofC in a tricky spot. 

Bottom line: Repairing the economy will need to be done outside monetary policy levers. The federal government and provinces are working on it: fast-tracking major projects, freeing internal trade, and expanding into new markets. The problem is the economy is weak today, and these policies will take time to provide meaningful impacts.

Getting back to ‘normal’

Things are starting to look a lot more normal today on the yield curve. With short-term rates falling, and the longer term (5-10 year) edging up, we’re getting back to the more typical pattern of (gently) upward sloping yield curve.

The implication is that the big rate cuts we’ve seen since mid-2024 are behind us, and that rates on longer term debt “will be challenged to fall significantly”, as Mark Johnson from our rates desk argued earlier this month.

Answer to the previous trivia question: According to madeinca.ca, Victoria has the most number of restaurants on a per capita basis in Canada.

Today’s trivia question: Which is the oldest central bank in the world?