The Bank of Canada cut its key interest rate to three per cent on Wednesday, but trade policy uncertainty looms over Canada’s economic outlook and clouds the future rate path.
The 25 basis point cut was widely anticipated as both inflation and inflation expectations moderated while interest rates remained restrictive. It also marked a return to a slower pace of rate cuts from the central bank after consecutive 50 basis point cuts in October and December.
Wednesday’s cut was needed for economic expansion to pick up following the restoration of price stability and with U.S. tariff threats fuelling broader concerns in Canada. Inflation expectations have also returned to historical norms.
The removal of the forward guidance highlights the level of uncertainty and prevents inflation expectations from de-anchoring.
The Bank of Canada also announced an end to quantitative tightening with plans to complete the normalization of its balance sheet and restarting asset purchases in early March.
What to watch next
Under the baseline scenario of no tariffs, two more cuts of 25 basis points cuts are expected in 2025 to bring the policy rate to neutral at 2.5 per cent by the end of the year.
The Canadian economy saw an increase in activity after back-to-back large cuts last year — but consumers and businesses are still holding back on spending and investments while anticipating further cuts.
Then there’s the ongoing uncertainty with U.S. trade policy. If tariffs were implemented and Canada responded with measures of its own, the central bank would face a challenging task. Tariffs could raise prices, which would prompt rate hikes, but aggregate demand would weaken and could lead to rate cuts.
If no tariffs take effect on Feb. 1, the next date to look out for is April 1 — when the report on U.S. trade balances is due. As of now, the Bank of Canada will make decisions one rate announcement at a time based on information that is available rather than uncertain threats.
Fed holds in U.S.
In the U.S., the Federal Reserve held its policy rate this afternoon. Wednesday’s rate cut puts the Bank of Canada’s rate 150 basis points below the Fed, which could cause the Canadian dollar to slide. But one could argue that the Canadian dollar has already dropped, and the focus now for the central bank is to maintain price stability against the backdrop of high uncertainty.
The business outlook survey that came out last week indicated that overall business sentiment in the country remains subdued. While hiring plans remain modest due to spare capacity, the survey suggested firms plan to increase investments and resume previously postponed plans driven by lower financing costs and improving demand outlooks.
The consumer expectations survey showed an improvement in financial health due to recent rate cuts. This contributed to improved consumer sentiment, with more consumers planning to increase spending on essential purchases, housing costs and discretionary items.
But economic uncertainty and high housing costs continue to weigh on spending decisions as consumer confidence in the labor market has weakened and inflation expectations have largely returned to historical norms.
Read more insights from RSM Canada in The Real Economy Canada. Click here to subscribe.
