Trade conflict: What can the Bank of Canada do?

Governor Tiff Macklem discusses how a trade conflict would affect the Canadian economy and monetary policy. He also outlines what the Bank of Canada is focusing on as it renews its monetary policy framework.

Canada’s trade relationships are changing

Trade between Canada and the United States has increased over the past 60 years, with both countries acting as the other’s number one export destination. However, President Trump has threatened to impose significant tariffs on Canada’s exports. And the Canadian government has said it will retaliate. The consequences of a full-scale trade conflict would be severe.

If large and lasting tariffs are imposed, this could cause a big supply shock and a drop in demand. This would be similar to what happened at the start of the pandemic. But while Canada’s economy returned to normal when the pandemic crisis ended, this time there will be no bounce-back. The economy would eventually start to grow again, but from a lower starting point. This is a structural change.

How tariffs would hurt the economy

A trade conflict would hurt growth and increase inflation in Canada. The effect on growth would happen through:

• Exports—Canadian goods would cost more in the United States, so demand would drop. This would sharply reduce Canada’s exports. The decline in exports would lead to layoffs and lower household incomes.
• Consumption—Lower household incomes would lead Canadian consumers to spend less. Retaliatory tariffs would also make many imported goods more expensive, prompting a further decrease in demand and spending.
• Business investment—Faced with higher costs and less demand from consumers, businesses would shelve their investment plans.

Tariffs would increase the cost of goods imported from the United States. The Canadian dollar could also depreciate, which would make all imported goods and services even more expensive. Higher prices would feed directly—and indirectly—into inflation, which would temporarily rise above 2%.

The role of monetary policy during a trade conflict

Central banks don’t have much leverage during a trade war. And monetary policy can’t respond to both lower growth and higher inflation at the same time. But the Bank of Canada can help the economy adjust to a trade shock.

If tariffs are imposed, demand is expected to fall more quickly than supply. This would hurt economic growth. Lower interest rates could help support demand during this period. But how much support monetary policy can provide is limited by the need to control inflation.

Tariffs will also lead to a one-time increase in consumer prices. If businesses and consumers start to expect higher prices, that one-time increase could spiral into ongoing high inflation. Higher interest rates could help ensure that the increase in inflation remains temporary.

We are starting our framework renewal

Since 1995, the Bank’s framework for monetary policy has been to target 2% inflation, the midpoint of a range between 1% and 3%. The post-pandemic inflation shock tested this framework like never before. But monetary policy worked, and inflation returned to 2%.

Canada’s economy is now facing a future rife with more frequent shocks and more structural change. That’s why we’ll be asking a few key questions as we begin the review of our framework—a process that happens every five years:

• With more supply shocks ahead, do we need a richer playbook for how we achieve the inflation target?
• How do we best measure underlying inflation in a more volatile world?
• How do monetary policy and housing interact?

The monetary policy framework has worked well for decades, so the bar for change is high. But the world economy is shifting, and the Bank must be as ready as possible for what lies ahead.