Price stability will fuel economic expansion in 2025 as the Bank of Canada reduces interest rates to a low of 2.75 per cent within the first half of the year.
Price stability will fuel expansion in 2025 as the Bank of Canada reduces interest rates to a low of 2.75 per cent.
The rate cuts will encourage investment and risk-taking, reduce financing costs on Canada’s elevated debt and put more cash in consumers’ pockets with lower mortgage payments.
But the 2.75 per cent terminal rate would still be above pre-pandemic levels, a signal to Canadian businesses and consumers that they are facing a new era of structurally higher financing costs.
Mortgage holders who renew their loans, for example, will face higher payments than the days of historically low interest rates. However, the sticker shock will be milder compared to those renewing over the past two years.
Similarly, businesses will need to adapt to the reality of higher financing costs. Businesses that coasted on the negative real rates before the pandemic will need to put a greater emphasis on operations and efficiency over managing their balance sheet.
All through this change in rates, Canada will be experiencing a demographic shift resulting from a tighter immigration policy.
For the past couple of years, open immigration policies bolstered Canada’s economy, driving consumer spending and easing the shortage of workers. The result was that Canada skirted a recession and instead had a soft landing.
New immigration restrictions would slow population growth, temporarily easing housing and infrastructure demands, thwarting aggregate consumer demand and making growth dependent on productivity gains.
As investments ramp up, so will hiring, and the job market will look up as the unemployment rate falls.
The youth unemployment rate will recede from its high level as demand for talent climbs, and the supply of temporary foreign workers dwindles, further keeping unemployment low.
The economy and productivity will also grow thanks to investments in capital and labour. When the labour part of the equation is not growing, capital investments—specifically productivity-enhancing measures—are even more critical.
Climate change will continue to impose costs on infrastructure, property and agriculture. The economic burden of extreme weather events like wildfires and floods necessitates investments in climate-resilient infrastructure, renewable energy and decarbonization.
A second Trump administration in the United States will have an undeniable impact on the Canadian economy as the U.S. remains the largest trading partner of Canada and the destination of three-quarters of Canada’s merchandise exports.
While tariffs are the biggest threat to Canadian exports, and industrials would be most affected, we do not anticipate a broad-based 10 per cent tariff on all goods in early 2025.
Instead, the early rounds of tariffs would be selective based on certain goods and countries of origin.
Canada might even benefit from friend-shoring in the short to medium term. It is pivotal for firms to prepare themselves for changes in trade policy.
A global economic recovery will ensue as economies return to price stability and major central banks cut their interest rates. A global recovery and a strong outlook for the United States would further propel the Canadian economy.
Growth outlook
Next year, there will be growth in a new regime of higher labour costs, a higher cost of capital and more uncertainty in the global economy.
In our baseline scenario, which we assign a 55 per cent probability to, projected growth will climb to two per cent in 2025 as the economy expands by 1.8 per cent in the first quarter, 1.9 per cent in the second quarter, two per cent in the third and 2.2 per cent in the fourth.
Since population growth will slow, household consumption needs to increase to support economic growth.
Household consumption is expected to rise as the Bank of Canada’s rate cuts alleviate the burden for mortgage holders, freeing up cash for consumer spending that would otherwise go toward mortgage payments. Renters will also benefit from a more balanced rental market.
Businesses in finance, technology and energy might take more risks and resume investments in a more favourable macro environment.
Read more of RSM Canada’s insights on the economy and the middle market.
To combat the higher costs of doing business, investments in technology and automation, including in artificial intelligence and robotics, will be of paramount importance.
In an alternative scenario, Canada could see a year of regressed growth at 1.2 per cent or even fall into a mild recession amid risks of household and corporate debt, labour shortages, a trade war and geopolitical tensions. We estimate the probability of that scenario to be 25 per cent.
A pronounced decline in population growth brings about downside risks to aggregate consumer demand. Individual spending would have to increase notably to overcompensate for the lack of growth.
Without the labour supply from immigration, including temporary workers, wage growth might not be mitigated from the four per cent to five per cent range, keeping services inflation elevated.
Housing costs, which are a structural problem beyond mortgage interest rates, would climb when prospective buyers get back into the market.
Add low productivity to the picture, and it’s easy to see how the Canadian economy could underperform in 2025.
Conversely, expansion could come back much faster than expected if investor interests rebound quickly, bringing growth to 2.4 per cent, which we estimate to have a 20 per cent occurrence.
Inflation could temporarily undershoot the Bank of Canada’s two per cent target, causing the central bank to lower its terminal rate below our forecast of 2.75 per cent.
The housing market will also play an important role as easing rate pressures bolster consumer confidence.
Inflation and monetary policy
We expect inflation to return to and stay on the Bank of Canada’s two per cent target next year. Headline inflation’s decline to 1.6 per cent in September shows that monetary policy works, and it is now the Bank of Canada’s goal to maintain inflation near two per cent.
Timing is crucial. The Bank of Canada will need to quicken the pace of rate cuts toward the terminal rate of 2.75 per cent with reductions at every meeting if the central bank does not want to undershoot the target so that monetary policy can support employment and growth.
The longer the Bank of Canada takes, the higher the risk of Canada having another quarter of lagging growth.
Inflation still has room to fall. The expectations have cooled, and this is an area where they drive reality.
Rent growth will moderate as more supply enters the market in 2025 and population growth slows. Already, rental prices have declined in major urban areas.
Rate cuts will also contribute to disinflation as they reduce mortgage payments. Currently, 28 per cent of headline inflation is made up of shelter, and 5.5 per cent is only mortgage interest rates.
Excluding mortgage payments, inflation has already fallen to one per cent, which means inflationary pressures have largely been stomped out. While core inflation measures remain above two per cent, they are on a gradual downward trajectory.
Goods deflation is already happening, although services inflation remains sticky. Even though the labour market has cooled off, wage growth remains near five per cent, well above inflation.
Slower labour supply growth from restricted immigration could keep wage growth—and services inflation—elevated well into 2025.
Of course, if the U.S. imposes a 10 per cent tariff on Canadian goods, and if Canada retaliates, inflation could rise since more than half of Canadian imports are from the U.S.
The interest rate and growth differentials between the U.S. and Canada will play a role in the growth and inflation outlook. The Federal Reserve’s terminal rate is expected to be higher than the Bank of Canada’s, at around 3.5 per cent, because the U.S. economy is expected to grow at a higher rate of 2.5 per cent.
The bond yield spread between Canada and the U.S. is expected to widen, with Canada bond trading lower.
The Canadian dollar has fallen to a multiyear low, with the Canadian dollar-American dollar exchange rate at 0.72 as of Nov. 12.
But given how integrated the Canadian economy is with the U.S., absent a full-blown trade war, the Canadian economy and dollar could benefit from strong growth in the U.S. compared to the European Union and other major economies.
Employment
The labour market will pick up as soon as early 2025 in an environment of price stability and accommodative monetary policy. The unemployment rate could peak at 6.9 per cent before falling toward 6.2 per cent.
As Canada accepts fewer new temporary residents in 2025, there will be a smaller growth in the workforce and fewer people looking for work, keeping unemployment low.
But with fewer new consumers, hiring will be reduced, resulting in a smaller increase in jobs overall.
Wage growth might moderate but not fall to the sub-3 per cent level that predominated before the pandemic. In this new era, elevated wage growth is here to stay as limited immigration keeps a tight labour supply.
The result is higher household income, and while that translates to a better economy, it also could lead to higher inflation.
This shift could benefit younger workers and newcomers in finding work but might constrain the talent pool, especially in specialized fields.
Without a steady supply of low-cost labour, employers may face upward pressure on wages.
Labour productivity could increase in the short to medium term thanks to slowed immigration. When the labour supply falls and capital stays constant or rises because of lower borrowing costs, the capital to labour ratio rises.
Assuming total factor productivity, which considers l abour and capital, stays constant, labour productivity will rise when the capital-to-labour ratio improves.
Many newcomers tend to take lower-wage jobs and have lower productivity. Fewer new workers will improve labour productivity using sheer math.
Having fewer workers is not a long-term solution to lagging productivity. Over time, labour unit costs have been steadily climbing in Canada without matching productivity growth. Further investments in capital and training are needed to lift productivity sustainably.
Housing
An accommodative monetary policy will give way to a more vibrant housing market and construction activity because these industries are highly sensitive to interest rates.
Rate cuts will smooth out the mortgage renewal wave. For those renewing their mortgages in 2025 and beyond, the bump in interest rate payments will be less of a sticker shock compared to renewals over the past couple of years when rates were increasing.
There will be a marked uptick in activity as buyers take advantage of reduced borrowing costs and sellers move to list their homes after sitting on the sidelines for years.
There will be a marked uptick in home-buying activity as buyers take advantage of reduced borrowing costs and sellers move to list their homes.
The release of pent-up demand will raise sale prices. The mortgage rates will be higher than before 2022, but such is the cost of homeownership in the post-pandemic economy.
Lower immigration targets will dampen demand, especially for rentals, in a year when more supply will come onto the market.
Construction projects will resume as rates fall. Multiple municipalities have changed zoning laws, making it easier to develop and add density at a time when population growth has far outpaced construction. All these factors make for a positive construction outlook in 2025.
Still, in the long run, Canada faces the structural challenge of housing unaffordability resulting from decades of underbuilding. Even if population growth halts in 2025, the existing domestic demand still far exceeds supply.
Continuing and expanding policies to boost supply will most likely have a far greater impact than piecemeal policies fueling demand, like extending the amortization period.
Because if supply does not increase, either from the unwillingness to add density or the sheer red tape that makes the cost of building prohibitively high, adding demand just drives up prices as more buyers compete for the same housing stock.
Immigration
The demographic shifts resulting from a stricter immigration policy will undermine aggregate consumption and potential gross domestic product growth while keeping unemployment low.
New targets would have Canada’s population projected to decline by 0.2 per cent next year, down from the robust three per cent increase in 2023 and, during the pandemic, the first decline since the early 1950s.
Still, given the practical hurdles of imposing such constraints, the most likely scenario would be a deceleration in population growth instead of an outright decline.
After years of using an open immigration policy to rejuvenate the workforce, fill gaps in the labour supply and buoy consumer spending, the federal government has shifted its stance on immigration.
Canada lowered the annual target for new permanent residents from the previous target of half a million in 2025 and 485,000 in 2024 to 395,000—a whopping 20 per cent drop.
There will also be the first-ever targets for temporary immigrants, which include international students and foreign workers, to admit 446,000 in 2025 and 2026.
The goal of Immigration, Refugees and Citizenship Canada, to put things into perspective, is to decrease the number of temporary residents from 6.5 per cent of the total population to five per cent by 2026.
We think the threat of mass forced deportation from the U.S. will not change Canada’s immigration outlook because it would face intense backlash and logistically be infeasible to implement. At most, selective deportation will result in a few thousand people crossing into Canada, which would not alter the workforce in any meaningful way.
Spending per capita will need to rise substantially to compensate for the lack of new consumers propelling spending.
Lower potential growth will mean that excess capacity in the economy could fall more quickly.
The growth outlook is much lower than under a high-immigration scenario, though unemployment will remain lower.
Businesses will no longer be able to rely on cheap labour and will have to focus on improving productivity if they want to thrive.
Risks to the outlook
A major downside risk lies in stagnant productivity amid a demographic slump. While the effectiveness of new immigration policies is unclear, and the net economic impact of new immigration targets remains to be seen, growth might undershoot projections if less immigration thwarts aggregate consumption.
New immigration targets would most likely be over-correcting, leading to talent shortages and a rebound with an aging workforce at a time when many Canadian workers are retiring.
Monetary policy remaining too tight for too long might undermine inflation and delay economic expansion.
If growth turns out to be weaker because of the demographic shift, the Bank of Canada might have to keep slashing rates.
The United States will remain a magnet for foreign investments in 2025. If Canada does not attract foreign investments and ramp up domestic investments in productivity, the risk will be below-trend growth over the long term, as well as the Canadian dollar trending lower.
On the upside, household balance sheets are poised to increase with rate cuts as assets grow at a faster rate than liabilities. Consumer spending could rebound more quickly and boost the economy more than expected.
Global geopolitical uncertainties could disrupt trade and immigration patterns as well as global energy supplies. Canada’s energy independence is a powerful buffer against these risks. The U.S.’s oil production is projected to increase under the Trump administration, which will help prevent spikes in oil prices and keep inflation in check.
The takeaway
The Canadian economy is expected to grow at around two per cent in 2025 as unemployment falls and price stability is restored.
The Bank of Canada will cut the policy rate at every meeting to return to a terminal rate of 2.75 per cent within the first half of the year. The accommodative financial conditions will stimulate hiring and investments.
We put the probability of a recession at 25 per cent, but the tightening of immigration threatens the growth outlook. The growth and interest rate differential between the U.S. and Canada threatens to keep investments flowing into the U.S. and weaken the Canadian dollar.
In a broader context,
Canada continues to undergo a regime change in a post-pandemic economy with a higher cost of capital, tighter labour markets, geopolitical uncertainties and disruptions of all industries thanks to development in artificial intelligence, quantum computing and robotics.
To manage risks and capitalize on opportunities, firms will need to invest in productivity-enhancing equipment while at the same time reinvesting in their workforce.
