Monetary Policy Report

Inflation remains close to 2%, and past cuts in interest rates are boosting economic growth in Canada. At the same time, the threat of wide-ranging tariffs by the new US administration has increased uncertainty.

Quarterly growth in gross domestic product (GDP) is estimated to have been about 1.4% in the second half of 2024. The labour market is still soft, and the economy remains in modest excess supply. Spending has begun to increase on housing and on goods and services that are sensitive to interest rates.

Consumer price index (CPI) inflation has remained around 2% in recent months, as expected in the October Report.

Economic activity

GDP growth slowed to 1% in the third quarter, weaker than anticipated at the time of the October Report. It is estimated to have increased modestly to around 1.8% in the fourth quarter (Chart 1).

Growth in final domestic demand has been solid and is estimated to have climbed to about 3.5% in the fourth quarter. This recent strength reflects continued robust growth in consumer spending and a pickup in residential investment. In contrast, business investment remains weak.

Uncertainty has risen in recent months because the new US administration has threatened to impose wide-ranging tariffs on Canada and many other major US trading partners. In Canada, there are signs that this uncertainty is weighing on consumer and business confidence and on investment intentions. The threat of new tariffs has also contributed to the recent decline in the Canadian dollar relative to the US dollar (see In focus: Recent factors affecting the Canada-US exchange rate).

Final domestic demand growth has been solid

The latest data available indicate that growth in final domestic demand was solid in the fourth quarter, led by growth in consumption per person and a surge in residential investment (Chart 2). This suggests that households are responding to lower interest rates. In contrast, growth in government spending has moderated, and business investment has remained flat.

Growth in consumption per person turned positive in the third quarter of 2024, and it is estimated to have increased further to about 1.6% in the fourth quarter. This rise is supported by cuts made to the policy interest rate in 2024 and robust growth in disposable income per person.

Residential investment is estimated to have increased sharply by about 15% in the fourth quarter of 2024 (Chart 3). Continued strong growth in home resales—which boosts ownership transfer costs—and a substantial rise in new home construction were supported by lower interest rates and pent-up demand. In contrast, renovation activity remained soft.

Business investment has been weak and is estimated to have remained flat in the fourth quarter (Chart 4).

While government spending growth was strong through much of 2024, it is estimated to have eased in the fourth quarter, in line with plans laid out in federal and provincial budgets and fiscal updates.

Exports rise in the near term

Exports were weak over the first three quarters of 2024 despite the strength in foreign demand. While part of this weakness likely reflects ongoing competitiveness challenges, temporary factors are also at play. These include short-term shutdowns at some Canadian and US motor vehicle facilities.

Export growth is estimated to have risen sharply to around 4.6% in the fourth quarter, mostly reflecting a surge in the exports of gold and pharmaceuticals, which tend to be highly volatile. This recent pickup also reflects the re-opening of some motor vehicle facilities, and export growth in the fourth quarter is further supported by increased oil exports.

Import growth is estimated to have increased to about 2.9% in the fourth quarter. This reflects a rebound in motor vehicle imports, partially offset by weak imports of machinery and equipment, which are restrained by subdued business sentiment.

Capacity pressures

The Canadian economy continues to be in modest excess supply. The output gap is estimated to be between -1.25% and -0.25% in the fourth quarter, roughly unchanged from the third quarter. Due to upward revisions to the level of GDP, there is slightly less excess supply than at the time of the October Report (see Changes to the projection in the Projections section). A broad suite of labour market data indicate ongoing labour market softness (Chart 5).

The labour market remains soft

The unemployment rate is somewhat higher than it was at the time of the October Report, with youth and newcomers continuing to be the most affected. Employment gains picked up, while the rate of increase in the working-age population slowed (Chart 6). In recent months, average job gains were strong enough to maintain the ratio of employment to the working-age population.

While wage growth remains sticky, the most recent data show some signs that it has begun to moderate. The slowing is most evident in private-sector wage growth. All wage growth leads to higher demand and, because of this, has some effect on inflation. However, the cost of producing consumer goods and services is most affected by private sector wages. Measures of private sector wage growth based on data from the Labour Force Survey (LFS) have moved closer to growth in private sector compensation per hour in the national accounts (Chart 7). Growth in LFS private sector wages slowed to 3.4% in December, down from 4.6% at the time of the October Report. The microdata-based measure of LFS private sector wage growth, which adjusts for compositional changes, declined to 3.4% in December from 4% in September.

The moderation in wage growth has reduced the risk that inflation in some services could prove to be more persistent than expected (see the Risks section of the October 2024 Monetary Policy Report).

The Bank judges that underlying inflation is close to 2%. There are no signs that inflationary pressures are broad-based. The share of CPI components rising by more than 3% is now below its historical average. Inflation expectations have largely returned to normal.

Inflation has remained around 2%

CPI inflation remains close to 2%. Shelter services price inflation is the only major component above its historical average (Chart 9). In particular, inflation remains elevated for rent and mortgage interest costs, but it has been easing.

At the same time, inflation in other major CPI components has generally been below historical averages. In addition, the GST/HST holiday is pulling down inflation over the near term, particularly in categories such as food services and semi-durable goods. By March 2025, the tax holiday will have ended, and inflation in these categories will go back up.

Goods price inflation remains soft

Inflation in goods prices was -0.1% in December, in line with recent months. Excess supply and past easing in cost pressures continue to weigh on inflation for many goods prices. Moreover, the temporary GST/HST holiday reduced inflation in some goods, including food, alcohol, children’s clothing and toys. These factors were partially offset by the recent depreciation of the Canadian dollar, which has had a small inflationary impact on the prices of imported goods.

Services price inflation has eased

Inflation in services excluding shelter eased to 2% in December from 2.3% in September. The temporary GST/HST holiday pulled down inflation in services excluding shelter, especially food services.

Inflation in shelter services eased to 5.1% in December, down further from 5.8% in September. This easing has been driven by slower growth in rent and mortgage interest costs. While recent data suggest that the average asking price for rents declined in December, rent inflation remains persistently elevated. The persistence of rent inflation mostly reflects a gradual and ongoing adjustment to past increases in new rents (see In focus: How the frequency of price changes affects inflation in the October Report).

CPI-median and CPI-trim remain above 2% largely because of the impacts of persistently high shelter inflation on the distribution of price changes.1 Chart 10 shows the distribution of inflation in December 2024 compared with its historical norm (from 1995 to 2019). The distribution of non-shelter components (Chart 10, blue lines) has largely returned to its historical norm. In contrast, shelter price inflation (Chart 10, yellow lines) is still being pushed up more than usual by components that are well above 2%.

Inflation expectations have almost returned to normal

Inflation expectations of both consumers and businesses have almost returned to normal (Chart 11). Consumers’ expectations eased further in the fourth quarter, and three-quarters of businesses now expect inflation to be between 1% and 3% at all horizons.

Endnotes

Economic growth in Canada is projected to rise to around 1.8% in 2025 and 2026, outpacing potential output, and excess supply is gradually absorbed. Inflation is expected to remain close to the Bank of Canada’s 2% target.

The economic outlook depends on several key assumptions (see Key inputs to the projection in the Projections section). Importantly, the projection does not incorporate any wide-ranging US tariffs. New tariffs could significantly affect the outlooks for growth and inflation (see In focus: Evaluating the potential impacts of US tariffs). Reflecting an increase in uncertainty about US trade policy, the projection includes a modest negative impact on Canadian business investment.

The easing of monetary policy contributes to the increase in economic activity by stimulating household and business spending. At the same time, exports are supported by new transportation capacity for oil and gas, along with the continued strength of the US economy.

The outlook for growth in Canada has been revised down since the October Report because of new government policies designed to slow immigration and updated assumptions related to outflows of non-permanent residents. Fewer newcomers lead to both fewer new consumers and fewer new workers, with little net impact on inflation (see Canadian outlook in the Projections section).

Economic activity

As the impacts of monetary policy easing continue to work through the economy, growth in gross domestic product (GDP) is projected to increase from about 1.3% in 2024 to around 1.8% in 2025 and 2026 (see Table 1 in the Projections section). Quarterly growth slows near the end of the projection to be more in line with potential output growth as the effects of monetary policy easing fade.

GDP growth is forecast to pick up

The path for economic growth over the projection reflects the net impact of two opposing forces (Chart 12).

• On one hand, growth in GDP per person strengthens in 2025. Per-person household spending is the main factor behind this strengthening, reflecting the effects of lower interest rates as well as rising incomes and household wealth. It also reflects one-time government measures designed to support consumption in the first part of 2025. Export growth and business investment also increase.
• On the other hand, population growth is assumed to slow. After reaching about 2.3% in the second half of 2024, population growth is assumed to decline to 0.5% in the second quarter of 2025, and it is assumed to remain at that pace over the rest of the projection.

On a quarterly basis, GDP growth slows near the end of the projection horizon to be more in line with potential output growth as the effects of monetary policy easing fade.

Excess supply is projected to be gradually absorbed

Growth in potential output is projected to slow from 2.5% in 2024 to roughly 1.5% in 2025 and 2026. The assumed slower pace of population growth over the projection pulls down potential output growth (see Key inputs to the projection in the Projections section). This is partially offset by an expected rise in growth in trend labour productivity.

GDP growth is anticipated to outpace growth in potential output in 2025 and 2026, resulting in excess supply being absorbed (Chart 13).

Growth in consumption per person is expected to increase

Consumption growth is expected to ease over the projection horizon, in line with slower population growth.

On a per-person basis, however, growth in consumption is projected to pick up and average around 1% in 2025 and 2026, supported by past cuts in policy interest rates, solid income growth and increases in household wealth from rising house prices. Consistent with this outlook, respondents to the Bank’s most recent Canadian Survey of Consumer Expectations signalled their intent to increase spending on discretionary items over the next 12 months (Chart 14).

Residential investment growth is forecast to be robust in 2025

Residential investment growth is expected to be robust, at about 6%, in 2025 (Chart 15).

• Declines in mortgage rates strengthen growth in resales. Recent rule changes for mortgage insurance are also expected to boost resales.
• Pent-up demand for housing supports new construction, but constraints will limit supply growth in the short term. These constraints include the amount of land available for new homes, zoning restrictions and a lack of skilled workers.

Growth in residential investment is projected to moderate to about 2.6% in 2026. The housing vacancy rate is anticipated to gradually rise as population growth slows and more homes are built. However, the vacancy rate is expected to remain relatively low.

Growth in business investment is expected to remain modest

Growth in business investment is expected to increase but remain modest, averaging 1.6% over the projection horizon. Stronger demand growth and past declines in interest rates strengthen business investment. Increased export capacity is projected to encourage investment in the energy sector. At the same time, the rise in trade-related uncertainty will weigh on businesses’ investment plans. Moreover, the recent depreciation of the Canadian dollar has made imported machinery and equipment more expensive.

Growth in government spending is assumed to slow in line with federal and provincial budgets and fiscal updates.

Export growth is supported by new transportation capacity for oil and gas

Export growth is projected to increase to about 2.2% on average. It is bolstered by the increased transport capacity provided by the Trans Mountain pipeline, along with new export capacity for liquefied natural gas that is expected to come online in mid-2025. Non-commodity exports grow slowly over the projection despite strong foreign demand.

Import growth is projected to pick up to about 2.4% on average in 2025 and 2026, broadly in line with growth in domestic demand.

Inflation outlook

Consumer price index (CPI) inflation is expected to remain close to target over the projection. The Bank’s preferred core measures of inflation are projected to gradually ease toward 2% as shelter inflation continues to decline (see Table 2 in the Projections section).

The temporary GST/HST holiday on some goods and services will continue to add volatility to inflation in the coming months. After reducing year-over-year inflation by 0.5 percentage points in December, the tax holiday will likely lower inflation by about 0.8 percentage points in January and by around 0.4 percentage points in February (Chart 16). By March, the tax holiday will have ended, and inflation will edge up. The impact of the tax holiday is concentrated in prices for food and alcohol at restaurants (Chart 16, included in orange bars).

Over the projection, inflation is anticipated to remain close to the 2% target (Chart 17).

Inflation in shelter prices is expected to continue to ease but remain above its historical average. Past declines in interest rates will continue to be reflected in slower inflation in mortgage interest costs. With asking rents falling for the first time in several years and population growth assumed to continue slowing, inflation in rent is anticipated to moderate further.1

In contrast, inflation in non-shelter components is projected to rise but remain somewhat below its historical average over the projection horizon. The increase comes about as excess supply dissipates and the recent depreciation of the Canadian dollar lifts inflation in the prices of imported goods.

Endnotes

Global economic growth remains near 3%, and headline inflation is close to central bank targets in many countries. However, uncertainty has increased amid political and trade tensions. The outlook does not incorporate new tariffs threatened by the United States.

The outlooks for inflation and global growth are broadly in line with the October Report (Chart 18; Table 3 in the Projections section). However, these outlooks are subject to greater uncertainty than normal. This uncertainty is due to US President Donald Trump’s threat to impose significant import tariffs (Chart 19). As well, several major economies are experiencing heightened political uncertainty.

In this context, developments in financial conditions have been mixed across countries. Markets expect fewer US policy rate cuts, and long-term US interest rates have edged up. Many advanced economies have seen their currencies depreciate against the US dollar.

United States

US economic growth is expected to remain robust in 2025 and to moderate in 2026. Solid growth in labour income and past increases in financial wealth continue to boost consumer spending. Inflationary pressures in core services are persisting, and inflation in the United States has ticked up slightly, although it is expected to ease in 2025.

The projection assumes that the Tax Cuts and Jobs Act will be extended. Other assumptions about US fiscal policy remain unchanged.

US growth is strong but expected to moderate

US growth is estimated to have averaged 2.9% in the second half of 2024 and is expected to decline gradually to a still-solid pace of around 2.3% in 2026. Consumer spending, which has been surprisingly strong, is underpinning growth (Chart 20).

Solid growth in household income and past gains in financial wealth continue to support consumer spending in 2025. The anticipated extension of provisions of the Tax Cuts and Jobs Act is expected to boost household spending into 2026. By the end of the projection, the pace of consumption growth is forecast to soften slightly to about 2.2%.

Growth is anticipated to slow over the projection for state and local government spending as well as for business infrastructure investment due to the fading effect of past federal incentives.

The US economic outlook is subject to greater uncertainty than usual. The new US administration has proposed lower personal and corporate income taxes, changes to regulatory and immigration policies, and wide-ranging tariffs. (See In focus: Evaluating the potential impacts of US tariffs.)

US services price inflation remains elevated and declines only gradually

US inflation, measured by the personal consumption expenditures price index, is estimated to have edged up in the fourth quarter of 2024 to about 2.4%. This rise is mainly due to additional upward pressure from inflation in prices for core services (Chart 21). Over the projection, inflation gradually eases as demand growth slows and shelter price inflation subsides.

Inflation in services prices is estimated to have remained elevated at about 3.8% in the fourth quarter of 2024 due to strong consumer demand and because some prices have been slow to adjust to past cost increases. As these prices adjust and domestic demand growth slows, inflation in services prices is expected to come down. In addition, easing growth in house prices and recent declines in new tenant rents are expected to reduce shelter inflation over time. Inflation in goods prices is expected to rise from its low level as the impact of past declines in prices for durables fades.

Further into the projection, inflation in the United States moves close to target, with the economy growing at a pace broadly in line with potential output.

Euro area

Euro area gross domestic product is expected to grow at a subdued pace of around 0.8% in 2025 before gradually strengthening to about 1.3% in 2026. Economic growth is expected to be weighed down by ongoing weakness in manufacturing. The manufacturing sector is struggling to adjust to structural challenges, such as a lack of infrastructure investment and relatively high energy prices, along with persistent competitiveness pressures.

Financial markets expect the European Central Bank (ECB) to further reduce its policy interest rates. This policy easing should support domestic demand and boost consumer and business sentiment.

Inflation in the euro area is expected to be close to the ECB’s target of 2% over the projection. In particular, inflation in core services is projected to ease, reflecting modest growth in consumer demand, slowing wage growth and the dissipation of temporary effects related to sporting and cultural events in 2024.

China

Growth in domestic demand in China is projected to rise in the near term, bolstered by recent policy announcements. These announcements include spending vouchers for households, debt support for local governments and policies to stabilize the property sector. Exports grew at a rapid pace in 2024, mostly due to rising production capacity and falling prices for China’s manufactured goods. The prices of manufactured export goods are expected to stabilize, leading export growth to slow in 2025.

Later in the projection, economic activity eases as the impact of cyclical policy measures fades and structural challenges, such as an aging population, hold back growth.

Commodities

Oil prices have risen in response to tightened sanctions on Russian oil amid low global inventories (Chart 22). In addition, the Organization of the Petroleum Exporting Countries (OPEC) and OPEC+ members (OPEC plus some non-OPEC oil producers) have again delayed unwinding voluntary production cuts. Brent oil is assumed to average US$80 over the projection, higher than expected in the October Report.

The Bank of Canada’s commodity price index excluding energy is largely unchanged (see Changes to the projection in the Projections section).

Equity market valuations in advanced economies have continued to rise. Measures of risk appetite have generally remained strong, with equity risk premiums and corporate credit spreads still low relative to historical levels.

The US dollar has continued to appreciate against most other currencies and recently hit an all-time high on a nominal trade-weighted basis. The value of the Canadian dollar has fallen against the US dollar to about 70 cents US but has remained more stable against a basket of other currencies (Chart 24).

Most of the recent strength in the US dollar appears to be due to an increase in the foreign exchange risk premium associated with holding non-US currencies. While the spread between US and Canadian policy rates has increased, Bank models suggest this has had only a modest impact on the Canada-US exchange rate. (See In focus: Recent drivers of the Canada-US exchange rate.)

Economic growth in Canada is expected to pick up, supported by past interest rate cuts, and inflation is projected to remain close to the 2% target.

The projection does not incorporate any new US tariffs (see In focus: Evaluating the potential impacts of US tariffs). Reflecting increased uncertainty about US trade policy, the outlook embeds a modest negative impact on business investment.

1. * Numbers in parentheses are from the projection in the previous Report.
2. † Numbers may not add to total due to rounding.

Sources: Statistics Canada and Bank of Canada calculations and projections

1. * See details on the key inputs to the projection. Numbers in parentheses are from the projection in the previous Report.
2. † Core inflation is the average of CPI-trim and CPI-median.
3. ‡ At the time the projection was conducted, 2024Q4 and 2025Q1 are the only quarters over the projection horizon where indicators exist to help inform real GDP growth. For longer horizons, fourth-quarter-over-fourth-quarter percentage changes are presented. They show the Bank’s projected growth rates of CPI and real GDP within a given year. As such, they can differ from the growth rates of annual averages shown in Table 1.

Sources: Statistics Canada and Bank of Canada calculations and projections

1. * Numbers in parentheses are projections used in the previous Report.
2. † Shares of gross domestic product (GDP) are based on International Monetary Fund (IMF) estimates of the purchasing-power-parity valuation of country GDPs for 2023 from the IMF’s October 2024 World Economic Outlook. The individual shares may not add up to 100 due to rounding.
3. ‡ The oil-importing emerging-market economies (EMEs) grouping excludes China. It is composed of large EMEs from Asia, Latin America, the Middle East, Europe and Africa (such as India, Brazil and South Africa) as well as newly industrialized economies (such as South Korea)
4. § Rest of the world is a grouping of other economies not included in the first five regions. It is composed of oil-exporting EMEs (such as Russia, Nigeria and Saudi Arabia) and other advanced economies (such as Canada, the United Kingdom and Australia).

Sources: National sources via Haver Analytics, and Bank of Canada calculations and projections

Key inputs to the projection

The Bank of Canada’s projection is conditional on several key inputs and assumptions. The Bank regularly reviews these inputs and assumptions and adjusts the economic projection accordingly. 

• The projection assumes that there are no new US tariffs. However, it does include a modest downward revision to business investment resulting from the increase in policy uncertainty.
• Population growth of people aged 15 and over is assumed to be 3.3% in 2024. Population growth is assumed to decline to 0.5% by 2026, 1.0 percentage points lower than forecast in the October Report. This revision reflects two factors:
  • lower permanent resident targets in the federal government’s 2025–27 Immigration Levels Plan, which was announced on October 24, 2024
  • downward revisions to the outlook for net flows of non-permanent residents, reflecting new information related to the duration of temporary permits
• Growth of potential output in Canada is expected to slow from about 2.5% in 2024 to around 1.5% on average over 2025 and 2026.
• The Bank estimates that the output gap is between -1.25% and -0.25% in the fourth quarter of 2024.
• The projection incorporates information from published federal and provincial budgets and recent fiscal updates that have been tabled at the time of writing.
• Over the projection horizon, the per-barrel prices for oil are assumed to be US$80 for Brent, US$75 for West Texas Intermediate and US$60 for Western Canadian Select. These prices are US$5 higher than in the October Report.
• By convention, the Bank does not forecast the exchange rate in the Monetary Policy Report. The Canadian dollar is assumed to remain at 70 cents US over the projection horizon, 3 cents lower than in the October Report.
• The nominal neutral interest rate in Canada is estimated to be in the range of 2.25% to 3.25%. The economic projection assumes that the neutral rate is at the midpoint of this range. The neutral rate is the rate to which the policy rate would converge in the long run, when output is sustainably at its potential and inflation is at target (i.e., after all cyclical shocks have dissipated). It is a medium- to long-term equilibrium concept. The Bank re-examines estimates of the neutral rate each year in April.

Endnotes

The prospect of wide-ranging US import tariffs is the most important risk to the outlook. Given the fast-evolving situation and the high degree of uncertainty, the Bank has chosen not to include new tariffs in the projection.

Risk of tariffs

US President Donald Trump has threatened to impose tariffs on major US trading partners, including a 25% tariff on imports from Canada and Mexico. Affected countries, including Canada, could respond with tariffs of their own. The scale, breadth and duration of a potential trade war is uncertain. Even if all these details were known, it would be difficult to predict with precision how the effects would flow through the economy. The magnitude and timing of the impacts will depend importantly on how businesses and households respond to higher prices for inputs and final goods.

A permanent—or at least prolonged—broad-based and significant increase in tariffs, together with retaliation, would have a substantial negative impact on economic activity in Canada. At the same time, inflation would likely increase, due to higher costs for imported final and intermediate goods. In the face of a trade conflict, the response of monetary policy must balance the downward pressure on inflation from excess supply in the economy with the upward pressure on inflation from new tariffs on imports.

A detailed discussion of the channels through which the Canadian economy would be affected by tariffs, including an illustrative scenario, can be found in the section In Focus: Evaluating the potential impacts of US tariffs.

Apart from the imposition of wide-ranging tariffs, the Bank’s outlook for inflation is subject to several upside and downside risks. Overall, the Bank views these risks to inflation as roughly balanced.

Main upside risks

There are two main upside risks: shelter price inflation could be more persistent than in the projection, and consumer spending could be stronger than anticipated.

Shelter price inflation could persist

Inflation in shelter prices is expected to slow gradually. However, because the housing vacancy rate is near a record low, past interest rate cuts and the recent changes in mortgage rules could lead to higher-than-anticipated house prices and rents. As a result, shelter price inflation and total inflation may slow more gradually than anticipated.

Consumer spending could be stronger

Canadians are saving a relatively higher share of their income than they typically did over the past two decades. With interest rates falling, however, the savings rate could return closer to historical levels. This could result in consumer spending that is significantly stronger than anticipated. If this risk were to materialize, it would create additional demand in the economy and place upward pressure on inflation.

The new US administration is considering sweeping tariffs on imports. While many important elements are unknown, these measures could be highly disruptive to the Canadian and US economies.

US President Donald Trump has said his government would impose tariffs of 25% on goods from Canada and Mexico. He has also threatened tariffs on goods imported from other countries. This could lead to countermeasures by the United States’ trading partners, including retaliatory tariffs.

Tariffs are taxes on imports that increase the price consumers and businesses pay for goods and services.1 Tariffs affect spending, trade flows, government revenue, exchange rates, employment, gross domestic product (GDP) and inflation. They could substantially disrupt supply chains in Canada, the United States and elsewhere around the world.

In general, the economic impacts for a country imposing import tariffs depend critically on how easily businesses and households can find non-tariffed substitutes. When substitutes do not exist or cannot easily be produced in higher quantities due to capacity constraints, tariffs are more disruptive to the real economy and lead to higher inflation. In contrast, the effects are more muted when close substitutes are readily available.

At a minimum, a permanent tariff will cause a one-time, permanent increase in price levels. Whether tariffs lead to ongoing inflation will mostly depend on how household and business expectations for inflation respond to tariff-related price level increases. When expectations are well anchored to the inflation target, tariff-related price increases will have less of an effect on other prices and wages. The increase to consumer price index (CPI) inflation will therefore be temporary.

The ultimate scale, breadth, timing and duration of any US tariffs remain highly uncertain. It is also unclear how affected countries, including Canada, will react.

An illustrative tariff scenario

Given the uncertainty around future global tariff policies at this time, the Bank has chosen a simple scenario to illustrate how the global and Canadian economies could be affected by a trade conflict. This is not a forecast, but rather a hypothetical scenario that makes the following important assumptions:

• The United States imposes permanent tariffs of 25% on all the goods it imports, including from Canada.
• In response, the United States’ trading partners, including Canada, impose retaliatory tariffs of 25% on their imports of goods from the United States.
• The pass-through of tariffs to prices for final goods is initially low but increases gradually over time. In the meantime, businesses’ profit margins are reduced because they absorb part of the increase in costs.
• Half of the tariff revenue raised by each country, including Canada, is transferred back to households, while the remainder is used to pay down debt.

In Canada, a trade conflict would negatively affect both exports and imports:

• US tariffs make Canada’s exports to the United States—its largest trading partner—less competitive, leading to a significant decline in the volume of exports.
• Because US tariffs are applied to goods from all its trading partners, global exports and GDP decline. Lower global demand in turn reduces commodity prices, including the price of oil—one of Canada’s major exports.
• Lower global activity further reduces demand for Canadian exports.
• Canadian imports decline because of Canada’s retaliatory tariffs on US goods. This leads Canadian households and businesses to substitute US goods for goods that are not subject to tariffs.

On the whole, Canada’s trade balance worsens. Together, lower net export volumes and weaker terms of trade lead to a depreciation of the Canadian dollar.

Canadian business investment also declines significantly due to a combination of weaker export activity and an increase in the cost of imported investment goods from the United States.

• The cost of machinery and equipment imported from the United States rises in response to Canada’s retaliatory tariffs and the depreciation of the Canadian dollar. Imports from the United States comprise about half of overall business investment in machinery and equipment in Canada.
• Lower business profits also weigh on business investment during the period when businesses partially absorb cost increases associated with Canadian tariffs.

Faced with less demand, Canadian exporters lower production and lay off workers. This, in turn, negatively affects the rest of the economy by reducing demand for goods and services that are not traded, such as housing and dining in restaurants. An increase in government transfers to households financed by tariff revenues provides a partial offset.

Over time, the decline in business investment significantly reduces potential GDP in Canada, leading to a permanent decline in GDP.

Inflation generally rises, reflecting the net impacts of two offsetting factors:

• GDP declines because of weaker net exports and weaker domestic demand, resulting in significant excess supply in the short run. Commodity prices also decline. Together, these factors weigh on CPI inflation.
• Canada’s retaliatory tariffs on all goods imported from the United States have a direct and indirect impact on consumer prices.
  • Imports from the United States of final consumer goods and intermediate inputs used to produce final goods make up about 13% of the CPI basket in Canada.
  • Prices paid by consumer-oriented businesses for other production inputs, such as equipment and machinery, also increase in response to tariffs.
  • Together with the depreciation of the Canadian dollar, these direct and indirect pass-through effects more than offset the drag from excess supply and lower commodity prices, leading to an increase in CPI inflation.

A quantitative example

Models can be very helpful for understanding the many ways tariffs could affect growth and inflation. To create the hypothetical tariff scenario, the Bank used its standard global and Canadian projection models in conjunction with a specialized trade model.3 This multi-model approach helps to better capture how tariffs on many different goods and countries affect key macroeconomic variables.

The absence of large, broad-based tariffs in the past makes it difficult to quantify with precision how their effects would flow through the economy. Therefore, in addition to the benchmark calibration, the Bank has produced a number of variations using different assumptions about how households and businesses respond to tariffs. However, the trade scenario is the same across each variation. In all cases, it is assumed that the United States increases tariffs on all imported goods to 25%, and its trading partners respond by increasing tariffs on imported goods from the United States to 25%. All results are presented relative to a no-tariff scenario.

Benchmark calibration

The benchmark calibration assumes the historical averages for:

• the response of US demand for Canadian exports to price changes.
• the amount of time it takes for cost changes to be fully passed through to the Canadian CPI (three years)

In the benchmark calibration, average annual GDP growth in the first year is about 2.5 percentage points lower than it would otherwise be (Chart 27, red bars). In the second year, it is about 1.5 percentage points lower. By the third year, GDP growth has roughly returned to normal. In other words, if annual average growth were projected to be 2% in years 1 and 2 with no new tariffs, then the growth forecast would be about -0.5% in year 1 and 0.5% in year 2 with the new tariffs.

While the effect of tariffs on the rate of growth is temporary, the level of GDP is permanently lower, reflecting a decline in the long-run level of Canadian productivity due to the distortionary effects of tariffs.

Because cost increases associated with Canada’s retaliatory tariffs are assumed to be gradually passed on to consumer prices over three years, CPI inflation is subject to sustained upward pressure over this period (Chart 28, red bars). Considerable excess supply and declining commodity prices largely offset the direct impact of tariffs in the first year, but inflation rises as excess supply is gradually absorbed in subsequent years.

Sensitivity analysis around the benchmark calibration

The assumption of wide-ranging 25% US tariffs and full retaliation represents a significant relative price shock for an economy like Canada with strong trade links to the United States. Tariffs affect supply and demand in complex ways, and some prices are more affected than others. Wages and other business costs also adjust. In turn, businesses are likely to change what they produce and how they produce it, while consumers substitute away from some goods and services in favour of others. Gauging the net impact on economic slack and inflation is difficult. In particular, the relative strength of the various forces acting on inflation depends critically on:

• how much Canadian export volumes decline and the related spillover effects to business investment
• how sensitive Canadian inflation is to tariffs on US exports to Canada, particularly for consumer goods

To illustrate these sensitivities, the Bank has created a number of variations on the benchmark calibration (Table 4). How these variations impact GDP growth and inflation is shown in Chart 27 and Chart 28.

Larger decline in US demand for Canadian exports

Estimates of the sensitivity of Canadian exports to price changes are based on historical data and are found to be quite low. However, in the case of such a large shock, it is possible that exports could fall by considerably more than predicted by the Bank’s projection models. Increasing the sensitivity for both commodity and non-commodity exports to US tariffs results in a more significant decline in exports and business investment and, as a result, weaker GDP growth (Chart 27, yellow bars). It also leads to a more significant depreciation of the Canadian dollar because Canada’s trade balance worsens by more than with the benchmark calibration.

The impact of weaker demand and a weaker dollar have partially offsetting effects on consumer prices. As a result, CPI inflation is only modestly lower than in the benchmark calibration (Chart 28, yellow bars).

Lower tariff pass-through to consumer prices

In the benchmark calibration, it is assumed that the increased costs associated with tariffs are fully passed on to consumer prices after three years, meaning that businesses no longer absorb any of the cost increase after that point. If instead only 50% of the cost increase associated with tariffs is passed on to consumers after three years, inflation declines in the first year. This decline occurs because the drag on inflation from excess supply and falling commodity prices now outweigh the effect of tariff-related price increases (Chart 28, green bars). In subsequent years, inflationary pressures are also lower than with the benchmark calibration.

GDP growth does not decline by as much as it does in the benchmark calibration (Chart 27, green bars) because prices rise by less and, as a result, consumer purchasing power declines by less.

Faster tariff pass-through to consumer prices

Since the adoption of inflation targeting in Canada, changes to input costs have not usually led to significant increases in inflation. This suggests that a large portion of input cost changes are initially absorbed in businesses’ profit margins. However, it became clear in the pandemic that large cost changes can be passed through to prices much more quickly. Because a 25% tariff would lead to a significant increase in costs for businesses, they may adjust their prices more quickly relative to the historical average. In this variation, the time it takes for businesses to fully pass through the costs of Canadian import tariffs is reduced from three years to one and a half years (Chart 28, blue bars).

With faster pass-through, inflation initially increases by more, but also comes back down more quickly relative to the benchmark calibration. The implications for GDP growth, relative to the benchmark calibration, are small (Chart 27, blue bars).

Endnotes

The Canadian dollar has declined against the US dollar since October 2024, mostly due to rising uncertainty around trade policies. A widening differential in policy interest rates between the two countries has also played a modest role.

In recent months, the rising uncertainty and the widening interest rate differential have both played a role in the depreciation of the Canadian dollar. The relative contribution of each component can be better understood by examining how they influence the exchange rate.1

To what degree do interest rate differentials affect the exchange rate? 

The widening differential between interest rates in Canada and the United States is one reason for the recent depreciation in the Canadian dollar. But how large of a role has it played?

The following example helps gauge the impact. Consider an investment in one-year treasury bills in Canada and in the United States. Both offer guaranteed returns after one year. If the return on the Canadian treasury bills decreases to 1 percentage point below the return offered by US Treasury bills, then investing in the United States becomes relatively more attractive. In this case, investor demand for Canadian dollars declines, and the market value of the Canadian dollar temporarily depreciates below its long-term value by about 1%. Because of this depreciation, investors now have reason to expect that the Canadian dollar will appreciate by 1% over the next year, which offsets the 1-percentage-point difference in returns between the bills.2

The above example roughly matches what has happened since October 2024. The widening differential between Canadian and US interest rates of about 1 percentage point has contributed to a roughly 1% depreciation in the Canadian dollar. This leaves most of the remaining observed depreciation since October 2024 unaccounted for.

Exchange rate risk can also affect the value of the Canadian dollar

Exchange rate risk also plays an important role in investors’ decisions and therefore affects the exchange rates between currencies.

Continuing with the above example, when foreign investors buy Canadian treasury bills, they bear the risk of unexpected changes in the value of the Canadian dollar while the asset is held.

During periods of heightened uncertainty, investors typically demand a premium to compensate them for the additional exchange rate risk or to cover the cost of purchasing insurance in the form of options or futures contracts. This premium is known as the foreign exchange rate risk premium, and an increase in its value is associated with a depreciation of the exchange rate.3

The risks around the Canadian dollar and other currencies have been amplified since the US election, partly due to the uncertainty caused by the threat of US tariffs (Chart 29). Activity in markets for options and futures contracts reveals the increased concerns that the Canadian dollar could depreciate further (Chart 30). For example:

• Asset managers have increased their short positions in currency futures, which protect against devaluation of the Canadian dollar.
• Prices have risen for other derivatives contracts, including options contracts, which are used to insure against a depreciation of the Canadian dollar.

These increased concerns have added to the foreign exchange rate risk premium and have contributed to the depreciation of the Canadian dollar.

How does each factor contribute to the change in the exchange rate?

The relative contributions from the interest rate differential and the foreign exchange rate risk premium on the recent depreciation in the Canadian dollar can be estimated.4 Bank of Canada staff find that:

• The widening interest rate differential is estimated to account for a relatively modest share of the overall depreciation.
• Most of the depreciation is explained by the foreign exchange rate risk premium (Chart 31).

Bank staff also find that most of the depreciation in the currencies of other advanced economies relative to the US dollar is explained by the changes in their foreign exchange rate risk premium. Indeed, these depreciations all share common timing and patterns (Chart 32).

The foreign exchange rate risk premium increases when uncertainty is heightened. While there are many reasons why uncertainty has risen in recent months, much is due to US President Donald Trump’s threat of import tariffs. In practice, it is very difficult to distinguish between exchange rate depreciations that reflect pure uncertainty effects and changes in market expectations about the long-run value of the exchange rate.

Endnotes