Canada

The BoC’s war on inflation, which entailed raising interest rates from March 2022 to July 2023, did indeed have some degree of success. The headline consumer price index fell from a 43 year high of 8.1% in June 2022 and has now been running close to the target of 2%. But the BoC’s favored core measures of inflation have been much more stubborn, staying between 2.4% and 2.7% for most of 2024. That’s not much progress towards the 2% target. So it has been too early to declare victory over inflation, and certainly wage earners know it. Since January 2021 when inflation started to accelerate, wages have grown 16% cumulatively, but the things that wage earners need to live have gone up even more: around 25% for food and shelter, and around 30% for gasoline. In other words, Canadian wage earners are still under water, and that’s why life still feels so expensive, and that’s one of the reasons why citizens have became disenchanted with Liberal policies.

In addition to sticky inflation, the growth side of the economy is stumbling. GDP is well below the long-term average, productivity is abysmal and unemployment has risen from 6.2% when the BoC started to cut rates to 6.7% by the end of 2024. Therefore, the BoC finds itself in the classic central bank dilemma of either increasing accommodation too soon, which could boost the economy but stoke inflation, or not increasing accommodation fast enough, which will choke off inflation but slow the economy. To complicate things even further for the BoC, the new federal government is likely to take measures to stimulate the economy such as cutting taxes and limiting immigration, both of which could stoke inflation, but the government may also try to limit spending which would (temporarily) slow the economy.

We believe the BoC’s most likely path will be to cut two or three times in 2025, bringing the overnight rate down from 3.25% in January to between 2.75% and 2.5% by the end of the year. That’s a much faster decline than the US Federal Reserve Bank, which will most likely set the fed funds rate to a range of 4.00% to 4.25% by the end of 2025. That in turn should drive the Canadian dollar (CAD) down even more than its decline during the last several months of 2024. A weaker CAD would make imports more expensive, thus increasing inflationary pressures, but it would also make Canadian exports cheaper which would increase demand, and thus offset any tariffs the US might impose (to a certain extent).

The outlook for Canada is challenging in 2025, with competing agendas and clashing policies. The BoC would like to be able to cut rates a bit more to make it easier to stimulate the economy, but that risks a resurgence in inflation, especially with the possibility of a tariff war and a weaker CAD. And the new government’s policies create an unknown balance of inflationary and growth impulses. Overall we believe that GDP growth will be around +1.7%, somewhat slower than the long term average, while inflation will remain sticky at 2.2%.