Bank of Canada Holds Policy Rate Steady
Today, the Bank of Canada once again held the policy rate at 2.25%. This is the bottom of the Bank’s estimate of the neutral overnight rate, where monetary policy is neither expansionary nor contractionary. With inflation hovering at 2.8% and core inflation falling to 2.0% (as of April data), the Governing Council sees the current overnight rate as appropriate, as the Bank continues to look through the inflationary impact of the war in Iran. The war is in its fourth month, and oil prices and interest rates have risen considerably as a result. The war is disrupting supply chains, weakening economic activity and pushing up inflation. At the same time, the US administration continues to propose new tariffs, and the future of CUSMA remains uncertain.
CUSMA negotiations are underway, but they are unlikely to go on beyond the July 1 mandatory date for the formal review of the pact required by the treaty. On that date, the U.S., Canada, and Mexico are each supposed to declare whether they want to renew the deal for another 16 years (out to 2036), renegotiate it, or decline to renew. The three countries are set to miss the July 1 renewal milestone, with negotiations expected to stretch on for months or potentially years. Missing the date does not kill the deal. If the three don’t agree to a full 16-year extension, the agreement stays in force and shifts into a mechanism of rolling annual reviews that can continue for up to a decade. The treaty doesn’t formally expire until July 1, 2036, unless a party withdraws entirely. US Trade Representative Jamieson Greer said that on July 1, “I don’t think we’re going to renew it outright, but we’ll engage in the separate negotiations” — explicitly signalling the date is a starting point, not a hard conclusion. Dominic LeBlanc, the minister responsible for US trade, met with Greer in Washington and afterward suggested that July 1 “shouldn’t be seen as a crucial date.” Mexican and US officials say the scope and complexity of the issues — auto rules of origin, the 50% Section 232 steel/aluminum tariffs, and other disputes — make resolution by July 1 unlikely.
While first-quarter GDP growth in Canada showed a small contraction, economic growth has been solid in the US, boosted by consumption and AI-related investment. In the euro area, growth is subdued, with higher energy prices weighing on activity. China’s economic growth continues to be supported by strong exports, while oil imports have slowed substantially. Oil demand destruction is evident as China has chosen to limit energy use and draw down inventories.
Financial conditions in Canada have eased since the April Monetary Policy Report (MPR). Global equity markets have been buoyant, and bond yields, though volatile, have generally trended higher. The Canadian dollar has weakened against the US dollar and other currencies.
Canada’s economy contracted in the final quarter of last year. It weakened a bit further in Q1, but incoming data suggest that the first-quarter figure was weighed down by the 10% surge in imports, which has already reversed in the newly released April merchandise trade data. The flash estimate for April GDP is a more solid 0.4% quarter-over-quarter level (or 1.6% at an annual rate). The central bank expects growth to rebound in Q2, but even so, the economy is expected to remain in excess supply.
As expected, Canadian CPI inflation rose to 2.8% in April. Measures of core inflation declined to about 2%, and the share of CPI components growing above 3% is close to its historical average. Food price inflation moderated but remains high, and shelter inflation continued to slow. With global oil prices still elevated—roughly $10 per barrel above our April MPR assumptions—total inflation is expected to hover around 3% in the near term before gradually easing towards 2%.
In other news, the US CPI inflation report for May was released this morning:
- US inflation accelerated again in May as the war in Iran pushed up energy prices, outpacing wages for a second straight month. The US consumer price index climbed 4.2% from a year earlier, the most since early 2023.
- Core CPI, which excludes food and energy, increased 0.2% from April, a touch below expectations and taking some of the sting out of the Fed debate.
- The energy index rose 3.9% in May, accounting for over 60% of the monthly all-items increase.
- But other categories saw slower gains or outright declines: Grocery prices rose 0.1%, while transportation services, health insurance and new vehicle prices fell.
- The breadth of price increases also declined, providing another sign that inflation has likely peaked.
- The S&P 500 opened lower while Treasuries and the dollar wavered on the news.
Overall, today’s US CPI report sent a clear signal that consumers are pulling back on nonessential spending, pushing back against businesses’ attempts to raise prices. This should ease fears of Fed rate hikes following the blowout May payrolls report. Bloomberg News suggests that they still expect the Fed to hold rates steady at the June 12 meeting and to cut the overnight fed funds rate by 25 basis points in the fourth quarter of this year.
Bottom Line
The Bank of Canada has shown its willingness to bolster the Canadian economy amid unprecedented trade uncertainty and a record oil price shock. Ottawa, too, has taken actions to reduce the burden of higher prices on Canadians by temporarily eliminating the excise tax on oil. PM Carney is also working to diversify Canada’s trade away from the US, a strategy that has thus far been remarkably successful. As the charts below show, Canadian export diversification is gaining momentum. In addition, goods imports are also shifting away from the US to the rest of the world.
We continue to maintain the view that the Bank of Canada will keep rates steady this year. If inflation broadens and accelerates, rate hikes are possible, but that is not our baseline forecast. The Bank of Canada will be reluctant to tighten into housing market weakness. While housing activity strengthened in May, momentum is muted, and affordability improvements are likely to taper off in the coming months as trade tensions and the war keep oil prices and interest rates elevated.
Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres
drsherrycooper@