Neutralizing monetary policy: The Bank of Canada rightly serves up another double dose of rate cuts

“With today’s larger-than-usual rate cut, the Bank of Canada made the right call and took its foot off the brake. Financial markets are currently betting that the Bank will maintain a neutral stance throughout 2025. However, if the massive economic risk from Trump’s tariff threat materializes, the Bank will have no choice but to quickly shift gears and hit the gas pedal.“

• Today the Bank of Canada lowered its policy rate by 50 basis points (bps) to 3.25%. This move was largely anticipated by financial markets after a sizable increase in Canada’s unemployment rate was revealed last Friday. Pricing before the announcement implied a strong likelihood (80%) of a larger 50 bps cut, rather than the typical 25 bps move.

• With inflation risks largely contained, Canada’s economy continues to underperform, while downside economic risks are rising. The Bank summarized today’s decision as follows: “With inflation around 2%, the economy in excess supply, and recent indicators tilted towards softer growth than projected, Governing Council decided to reduce the policy rate by a further 50 bps to support growth and keep inflation close to the middle of the 1-3% target range.”

• The Bank also acknowledged Trump’s tariff threat: “…the possibility the incoming US administration will impose new tariffs on Canadian exports to the United States has increased uncertainty and clouded the economic outlook.”

• Taking a step back, the good news economic story of 2024 was that inflation fell faster than expected. It’s now back to the Bank’s 2% target, and has been inside the inflation control range for 10 consecutive months.

• At the same time, Canada’s economy continues to operate below its potential, with labour market slack increasing. And after two years of exceptional immigration growth, the economy has struggled with real GDP per capita (a common measure of aggregate living standards) down almost 3.5%. GDP in the third quarter was slightly below the Bank’s forecast (i.e., 1.0% vs. 1.5%), while the fourth quarter is also shaping up to under-perform the Bank’s forecast. Looking to 2025, lower immigration targets present yet another downside risk to the potential Trump tariffs.

• As such, our base case expects interest rates in Canada will ultimately need to fall below the Bank’s “neutral level” (lower bound of 2.25%) in 2025. A more accommodative stance will likely be warranted to help support the economy (given growing downside risks from Trump’s tariff threats and slowing population growth due to stricter immigration targets). Canadian businesses can expect short-term borrowing costs to continue easing going forward. For households, longer term borrowing costs have already fallen, but variable-rate mortgage holders may still benefit as rates come down further.

• Meanwhile south of the boarder, markets are betting (with a roughly 95% chance) that the U.S. Federal Reserve will cut rates by 25 bps on December 18. Therefore, we expect the gap between Canadian and American rates to grow in 2025, causing the Canadian dollar to depreciate against the U.S. dollar. While a weaker CAD adds to inflation pressure by making imports more expensive, the exchange rate is a key shock absorber that could help partially cushion the hit to Canadian exports if Trump follows through on his tariff threats.