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The Canadian economy remains under pressure amid trade tensions and a softer labour market. GDP surprisingly rose by 2.2% in the first quarter of 2025 due to tariff frontrunning from U.S. firms. However, Canada’s outlook is increasingly uncertain pending the status of U.S. trade negotiations. We remain optimistic on imminent progress in these negotiations and with domestic momentum appearing to stabilize, we view risks to the Canadian economy as turning more favorable.
Canada’s unemployment rate rose to 7% in May, and we anticipate this rising to 7.5% by year-end. Consumer and business sentiment has recovered since Liberation Day on April 2, but we expect trade uncertainty will impair business investment and household consumption going forward. Despite starting the year with a 1.7% GDP forecast for 2025, we now expect growth of just 1.25%, with equal balance to upside and downside risks.
The Bank of Canada (BoC) held its policy rate at 2.75% at its June meeting, citing persistent uncertainty around U.S. trade policy and the mixed economic signals at home, including firmer-than-expected core inflation and a higher unemployment rate. Given this uncertainty, we anticipate that the BoC will resume easing later this year, cutting the overnight rate to 2.25% by the end of the year. Slowing population growth will also negatively impact growth.
On a positive note, Canada now has the lowest U.S. tariff rate of any major trading partners. CUSMA exemptions resulted in most Canadian goods crossing the U.S. border tariff-free in April. The U.S. and Canada are expected to finalize a trade agreement in coming months, the outcome of which will materially weigh on our outlook. The digital services tax (DST), which was recently dropped by Canada in order to resume negotiations for a deal with the U.S, eased tensions and increased the likelihood of progress on trade negotiations.
The BoC held its policy rate at 2.75% at its last two meetings in April and June after seven consecutive cuts. We expect the central bank to cut rates twice this year and not go below the lower end of its policy rate for a few reasons. First, the BoC has clearly stated that it is more focused on current inflation than on economic weakness. Second, expansionary fiscal policy, which includes spending on major infrastructure projects, increased defence spending and a focus on increasing housing supply, likely puts a floor on how low the policy rate can go. Third, monetary policy has a widespread impact on the economy and is not an effective targeted mitigation for industries most impacted by tariffs.
The BoC has pointed to “unusual uncertainty” in the economy and mentioned that conflicting data, particularly on core inflation measures, led to the governing council proceeding carefully. We expect the policy rate to end the year at 2.25% given labour market strains, a weak housing sector, soft final domestic demand, and downward pressure on core inflation. Also, slowing population growth coupled with increased economic slack reduces Canada’s potential growth and will decrease the neutral rate. Thus, a 2.25% policy rate will be more restrictive relative to the time prior to the imposition of tariffs. Finally, cuts to interest rates may help stimulate the economy sooner than many of the Federal government’s other targeted fiscal initiatives including Bill C5, the One Canadian Economy Act that aims to remove interprovincial trade barriers, fast-track major projects and increase labour mobility.
May inflation numbers had a deceptively soft inflation rate of 1.7% for headline inflation and an elevated 3.0% rate for core inflation, both for median and trim measures. Lower flash estimates for manufacturing sales indicating a drop of 1.3% are pointing to some signs that the Canadian economy is starting to feel the impact of U.S. tariffs.
The low headline inflation number was deceptive because it had been pushed down by both the GST holiday which ended in mid-February and the consumer carbon tax which was removed in April. The BoC’s core measures were also influenced by disruptions that Tiff Macklem, governor of the BoC, categorizes as creating “unusual volatility.” Core inflation was likely pushed higher due to lagged effects from a weaker Canadian dollar which put upward pressure on the cost of U.S. imports.
We expect aggregate demand to slow due to several factors including a rise in unemployment and stalled population growth resulting in slowing economic activity that should keep inflation within the BoC’s target range of 1.0% to 3.0%. We expect year-end inflation to be 2.5%. Elevated mortgage rates, relative to pre-pandemic lows, implies that Canadians have less discretionary income. Additionally, continued uncertainty around U.S. trade policy has put downward pressure on inflation as businesses hold back on hiring, spending, and investing. Consumers are also holding back on purchases, particularly big-ticket items.
Inflation numbers for food, travel services and healthcare were still elevated in May. Shelter inflation, which has an almost 30% weight in the CPI, is still elevated, contributing to over 50% to the rate of inflation. This is despite the fact that rents are falling amid slowing population growth and declining mortgage interest costs.
The BoC is particularly concerned with inflation anchoring, which can create a wage-price spiral as workers will demand higher wages if they have higher expectations for inflation. High inflation expectations also increase uncertainty as it’s more difficult to ascertain the actual rate of inflation. Inflation pass-through rates also rise in this scenario as businesses are more receptive to increase inflation if consumers expect it. As we see from the chart below, inflation expectations have ticked up this year although the 5-year-ahead remains well anchored.
Ashish Dewan CFA, CFP is Senior Investment Strategist at Vanguard Investments Canada. Excerpted from Vanguard’s “Economic Outlook for Canada – Q2 2025”.
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