OTTAWA — The potential for U.S. tariffs is clouding the economic outlook for the Bank of Canada as it delivered another interest rate cut, reducing its policy rate by a quarter-percentage point to three per cent.
The cut, the central bank's sixth consecutive one since June, comes as the bank said inflation is sitting around its two per cent target and the economy is picking up speed.
"There are signs economic activity is gaining momentum as past interest rate cuts work their way through the economy," Bank of Canada governor Tiff Macklem said in prepared remarks on Wednesday.
But Canada’s economic outlook is mired in uncertainty with U.S. tariffs looming.
U.S. President Donald Trump has threatened Canada with 25 per cent tariffs across the board, but when he might make good on his promise — and to what extent — remains to be seen. They're still slated to come as early as Saturday, Trump's press secretary confirmed on Tuesday.
However, on Wednesday, Howard Lutnick — Trump's pick for commerce secretary — said at a Senate confirmation hearing that tariffs could come in two stages.
One on Saturday as planned to address Trump's concerns along the border, and another in the spring in a bid to move manufacturing back to the U.S.
As such, the central bank wants Canada's economy to be in the best position possible to handle a tariff war, since its own tools are limited beyond interest rate changes.
"Tariffs mean economies simply work less efficiently — we produce and earn less than without tariffs. Monetary policy cannot offset this," Macklem said.
"What we can do is help the economy adjust. However, with a single instrument — our policy interest rate — we can’t lean against weaker output and higher inflation at the same time."
Asked to elaborate on what the Bank of Canada's role would be in a trade war, Macklem said the bank will be weighing a couple factors.
"If the weakness in the economy that comes through as a result of tariffs, and the downward pressure that's putting on inflation, comes faster than the upward pressure, then monetary policy, I expect, will be supporting growth," Macklem told reporters at a press conference.
"On the other hand, if the inflationary pressures come through faster and are bigger, monetary policy will have to be more focused on guarding against persistent inflation."
In its monetary policy report also released Wednesday, the Bank of Canada revised lower its GDP forecast.
It expects the country’s GDP to grow 1.8 per cent in 2025 and 2026, down from its previous projections of 2.1 and 2.3 per cent, respectively.
The revised projection factors in lower population growth — and population decline in 2026 amid new federal immigration targets — as well as a downward revision to business investment from increasing policy uncertainty.
But the forecast assumes Trump won’t make good on his tariff threat. If he does, the outlook is far bleaker.
“We don’t know the scope of retaliatory measures or what fiscal supports will be provided,” Macklem said.
“And even when we know more about what is going to happen, it will still be difficult to be precise about the economic impacts because we have little experience with tariffs of the magnitude being proposed.”
Stephen Brown, deputy chief North America economist at Capital Economics, said any tariffs would hit the economy hard.
"But the bank hinted today that it might have to refrain from providing monetary policy support, because otherwise there could be a risk that inflation takes off again," Brown said.
"That is in turn a risk to our view that the bank will cut twice more this year."
The central bank presented four scenarios if the U.S. hits Canada with 25 per cent tariffs, and Canada responding in kind dollar-for-dollar.
The impact, the Bank of Canada projected, would lower Canada’s GDP by 2.4 per cent in the first year whenever tariffs come in.
Such a scenario — what the central bank is calling its "benchmark calibration" — assumed Canadian exports react to price changes in line with historical norms and the cost of tariffs were fully passed on to consumer prices over three years.
So, if Trump imposed tariffs this year, the shock could be large enough to send Canada into a recession — by comparison of the Bank of Canada’s projection of a 1.8 GDP growth in 2025.
"The scenario we chose is a severe scenario. This is permanent. It's not sort of a first shot to subsequent negotiation," Macklem said.
In another scenario, using the same parameters as the benchmark except the cost of tariffs are passed on in half the amount of time, the impact to Canada’s inflation rate in the first year could be 0.8 per cent, and 1.3 per cent in the next year.
"We don't have a lot of good, historical examples where we've had tariff shocks of this magnitude, so we can't just go and estimate what would happen over history," Macklem added.
Scotiabank's head of capital markets Derek Holt said if no tariffs come to fruition, he expects the Bank of Canada is done cutting rates now that it's reached three per cent.
"Absent tariffs, it's a constructive outlook and they're not indicating appetite toward doing more," Holt wrote in a note to clients.
"I don’t buy their dismissal of momentum in core inflation measures in month-over-month (seasonally-adjusted annual rate) terms and so I think that’s an added reason they’d probably never admit."
However, CIBC Capital Markets chief economist Avery Shenfeld said interest rates are "still too high" considering the weakness in the jobs market and easing inflation.
"The combination of a labour market that the bank describes as “soft” and underlying inflation judged to be near two per cent tilts the policy balance towards a further (three-quarters of a percentage point) in cuts in our forecast, particularly as the tariff threat weighs on confidence," he said in a note to clients.
"On tariffs, the bank is in the throes of a major research effort, but seems to believe, as we do, that a trade war would have only a temporary lift to inflation, but could entail a material hit to growth that wasn’t factored into their forecasts."
In December, the Bank of Canada signalled that more rate cuts would be coming through 2025, but it would take a more gradual approach to them — in contrast to the back-to-back jumbo cuts that closed out 2024.
"Strikingly, in its policy statement, the bank dropped the line from December that 'We will be evaluating the need for further reductions in the policy rate one decision at a time' and it was not replaced with anything resembling forward guidance," said Brown.
"That decision may reflect the fact that the policy rate is now within the bank’s 2.25 per cent to 3.25 per cent neutral range estimate, or it may reflect uncertainty about how the bank might need to respond if tariffs are imposed."
This report by The Canadian Press was first published Jan. 29, 2025.
Nick Murray, The Canadian Press