Bank of Canada expected to cut interest rate again as trade war with U.S. disrupts economy

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With U.S. President Donald Trump shaking the foundations of the integrated North American economy, the Bank of Canada is widely expected to cut interest rates for a seventh consecutive time on Wednesday.

At its last rate announcement in January, the central bank lowered its benchmark rate by a quarter-percentage point, to 3 per cent, as insurance against the possibility of a trade war. Since then, Mr. Trump has imposed crippling tariffs, partially lifted them, and threatened more, disrupting commerce and sowing confusion for Canadian businesses and households.

Bank of Canada Governor Tiff Macklem has said repeatedly that monetary policy is ill-equipped to respond to trade disruptions. Tariffs hit economic growth and employment, but they also push up prices. That forces central bankers to choose between lowering interest rates to support the economy and raising them – or at least holding them steady – to head off inflation.

In the current circumstances, traders and analysts expect the bank to focus more on the risk of a recession than the rise in imported goods prices as Ottawa retaliates with its own tariffs and the Canadian dollar depreciates.

“There will be a one-off bump in inflation… But in the context of an economic slowdown, rising unemployment, and reduced household spending power, that’s much less likely to spark a sustained wage-price spiral,” Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, said in a note to clients.

“The [Bank of Canada’s] job is to keep an eye further out on the horizon than a month or two. It can’t reopen a shuttered factory with a few rate cuts, but it can support domestic demand as an offset,” he wrote.

Financial markets put the odds of another quarter-point rate cut this week at around 80 per cent, according to LSEG data. That would bring the policy rate to 2.75 per cent, the midpoint of the “neutral” range – the bank’s estimate for the interest rate level that neither stimulates nor restrains the Canadian economy.

The bank has been steadily lowering interest rates since last summer. If it wasn’t for Mr. Trump’s trade war, there would be good reasons to hit pause on its easing cycle.

Inflation has been hovering around the bank’s 2-per-cent target for the past six months, but the bank’s preferred measures of core inflation, which capture underlying price pressures in the economy, are running near the upper end of the bank’s 1 per cent to 3 per cent control band. Recent inflation readings have also been flattered by the federal GST holiday which ran from mid-December to mid-February.

The Canadian economy is also in better shape heading into a trade war with the U.S. than many economists expected. Gross domestic product grew at an annualized rate of 2.6 per cent in the fourth quarter of 2024, well ahead of Bay Street of Bank of Canada estimates. GDP data for the third quarter was also revised upwards, suggesting the Canadian economy was responding positively to interest rate cuts through the back half of last year.

The February jobs numbers, published Friday, however, showed signs of weakness, with the labour market adding only 1,100 jobs and the unemployment rate holding steady at 6.6 per cent. But that follows several months of strong job growth.

The problem is what lies ahead. Mr. Trump has partially backed down on the most serious tariff threat. He imposed 25-per-cent tariffs on imports from Canada, with a lower 10-per-cent rate on energy, critical minerals and potash, but then exempted all goods that are compliant with the United States-Mexico-Canada Agreement for a month. But this may only be a temporary reprieve.

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Moreover, Mr. Trump has vowed tariffs on a range of other Canadian industries, including steel and aluminum, lumber, dairy and copper. The 25-per-cent levies on steel and aluminum imports are scheduled to come into force on Wednesday, the same day as the Bank of Canada rate decision.

These tariffs will be hugely disruptive for many Canadian businesses, and the threat of them is already having a chilling effect. A KPMG survey of 602 export-oriented companies published last week, found that more than half had already begun reducing production or laying off employees in anticipation of tariffs.

“Many businesses are hesitant to build or expand operations in Canada given the uncertainty. Even with the US administration delaying implementation of tariffs on some products, that investment is unlikely to return to Canada in the same magnitude,” Royce Mendes, head of macro strategy at Desjardins, said in a note to clients.

“That bleak outlook for business investment coupled with the known headwinds from slowing population growth and the ongoing mortgage renewal cycle should be enough to push central bankers to lower rates further,” he wrote.

Mr. Macklem has warned that a major tariff shock could push the Canadian economy into a recession in the coming quarters. Central bank modeling suggests a prolonged trade war – with tariffs at the level Mr. Trump imposed this week, then waffled on – could lead to an 8.5-per-cent drop in exports, a 12-per-cent decline in business investment and a 2-per-cent drop in consumer spending. That would lower Canadian output by 3 per cent compared to a non-tariff scenario over the next two years.

These numbers are simulations, not forecasts. What actually happens will ultimately turn on the whims of the mercurial Mr. Trump – something no economic model can predict.

The bank will likely play a secondary role in responding to the crisis, with Ottawa and the provinces taking the lead with financial support for hard-hit businesses and workers. But Mr. Macklem suggested in a speech last month that the bank won’t just sit on its hands.

“Provided the inflationary impact of tariffs is not too big, monetary policy can help smooth the adjustment by supporting demand so it doesn’t weaken too much more than supply,” he said.