Market News

By Randy Thanthong-Knight

(Bloomberg) -- Bank of Canada Governor Tiff Macklem has managed to wrestle inflation back under control. But a looming US-Canada tariff war now threatens to undo his work on price stability.

The Canadian central bank cut interest rates Wednesday for a sixth straight meeting in a bid to strengthen economic growth after consumer prices stabilized near the 2% target since mid-2024. But the January decision and its new economic projections largely didn’t consider the impact of a potential trade spat, which could begin as early as Saturday.

The bank instead published a hypothetical but grim scenario where the US imposes permanent 25% levies on all goods it buys from its northern neighbor and Canada retaliates in kind, with pass-through prices to consumers increasing gradually. Such actions would lower gross domestic product growth and accelerate inflation in both economies.

“A long-lasting and broad-based trade conflict would badly hurt economic activity in Canada. At the same time, the higher cost of imported goods will put direct upward pressures on inflation,” Macklem said in prepared remarks. “Unfortunately, tariffs mean economies simply work less efficiently - we produce and earn less than without tariffs.”

In the US, prices American consumers pay for imported goods would increase, leading to higher inflation, although a stronger greenback would provide a partial offset. Gross domestic product growth would slow because retaliatory tariffs from Canada and other countries would lead to a significant substitution away from US exports.

For Canada, the trade conflict would negatively affect both exports and imports, especially because the US is its largest trading partner. The country’s trade balance would also worsen. Lower net export volumes and weaker terms of trade would then lead to a depreciation of the loonie, which has already been weakening against the US dollar in recent months.

A combination of weaker export activity and an increase in the cost of imported US goods, such as machinery and equipment, would prompt business investment to decline and over time lead to a permanent GDP drop. Canadian exporters facing less demand would lower production and lay off workers, which in turn would reduce demand for other goods, services and housing. Government transfers, financed by tariff revenues, may provide a partial offset.

But the drag on inflation from weaker growth and expected decreases in commodity prices wouldn’t be able offset the effects of the depreciation of the Canadian dollar, rise in input prices for businesses and price increases for products from the US, which make up about 13% of Canada’s consumer price index basket. That means inflation would accelerate in Canada.

Macklem said, however, that “absent the threat of tariffs, the risks to the inflation outlook are roughly balanced.” He said policymakers are equally concerned with inflation rising above 2% or falling below that level.

Taking away the potential trade conflict clouding over the Canadian economy, the bank forecasts GDP growth will strengthen to 1.8% this year and next, from 1.3% in 2024. But the projected increases for 2025 and 2026 were revised downward from previous forecast, largely due to slower population growth, a result of Canada’s immigration reduction plan.

“With inflation back around the 2% target, we are better positioned to be a source of economic stability,” Macklem said. “As we consider our monetary policy response, we will need to carefully assess the downward pressure on inflation from weakness in the economy, and weigh that against the upward pressure on inflation from higher input prices and supply chain disruptions.”