Bank of Canada cuts rates as it warns trade war 'would badly hurt economic activity in Canada'

Canada’s biggest banks reduced their prime rates Wednesday afternoon after the Bank of Canada cut its benchmark interest rate by an additional 25 basis points on Wednesday.

RBC, BMO, TD and CIBC each lowered their prime rates by 25 basis points, from 5.45 per cent to 5.2 per cent. The new rates are effective January 30. The Bank of Nova Scotia is expected to follow suit.

The prime rate is the annual interest rate that banks and financial institutions use to set interest rates for variable-rate mortgages, lines of credit, and some other loans.

Canadian Chamber of Commerce chief economist Stephen Tapp says the BoC should “lean into supportive mode” in the event of a trade war.

“Cut rates to backstop confidence, and let the exchange rate depreciate to act as shock absorber,” Tapp stated on Wednesday. “This is one way to help ease the economic transition, and help struggling Canadian workers and businesses deal with a significant external shock.”

He couched this with warning about the knock-on impact to inflation.

“I acknowledge this carries the risk of inflation expectations rising quickly, after the big pandemic inflation price level overshoot we just lived through,” Tapp added. “But the Bank’s own numbers are not too worrying on the inflation pressures.”

The BoC’s various communications today — news release, monetary policy report, Macklem’s speech and the press conference that followed — “indicated that if extreme assumptions about tariffs are not realized, then they are probably done cutting and will let lagging effects of cuts take over,” Scotiabank economist Derek Holt argues.

The BoC’s latest economic forecasts show growth picking up, Holt says. “As a result, their base case revised up their inflation projections and they view the risks around the 2 per cent inflation target as balanced. Absent tariffs, it’s a constructive outlook and they’re not indicating appetite toward doing more.”

Holt’s read of the tariff scenarios is that further easing is not guaranteed and that the BoC’s position is defined by “ambiguity.” Easing would be likely in a case where price increases don’t become pervasive and the economy suffers, he says. But in a situation where “tariff impact does create spillover effects,” he writes, “they’re going to focus more on inflation and less on growth. That could mean either they’re cutting less, maybe not at all, and possibly hiking.”

RBC Royal Bank announced a decrease to its prime rate by 25 basis points following the Bank of Canada’s policy rate cut, bringing it to 5.2 per cent from 5.45 per cent. The new rate is effective Jan. 30.

Canada’s other major banks are expected to follow suit this afternoon.

The degree of uncertainty facing the BoC is unprecedented, writes RBC chief economist Frances Donald, opting for a vivid simile to describe it:

“If central banks use the idea that setting monetary policy in uncertain times is like walking around in a dark room and trying not to trip on furniture, the BoC could more appropriately be described as blindfolded with projectiles being thrown at it.”

Absent a trade-war shock, the BoC would likely end up with its overnight rate at 2 per cent by year end, Donald says. A tariff scenario would “keep the BoC on a dovish bias” she writes, and result in cuts going deeper and possibly happening faster.

“Unlike a provincial or federal government, the BoC doesn’t have to keep any ‘powder dry’ for what’s ahead. The central bank has the luxury of preparing the economy with this cut, and, we expect, future cuts as inflation is now comfortably below two per cent for three of the past four months.”

Desjardins expects the Bank of Canada will reduce its policy rate by another 75 basis points to 2.25 per cent before 2025 is over.

However, economists Randall Bartlett and LJ Valencia say a large-scale trade war with the U.S. may warrant deeper cuts.

“If a full-blown trade war breaks out, expect the policy rate to fall faster and further,’ they wrote in a research report on Wednesday.

They also note the potential effects of slower population growth and “the impending wall of mortgage renewals” as factors favouring of cuts.

“The BoC attempted to address the competing headwinds facing the Canadian economy,” Bartlett and Valencia wrote. “While the guidance is helpful, the future will no doubt unfold differently.”

For real estate developers, the threat of tariffs — and not today’s cut — is the main focus, Adrian Rocca, CEO of rental housing developer Fitzrovia, said in a statement. The rising costs and disrupted supply chains resulting from a trade war “mean higher construction expenses overnight,” he said.

“Governor Tiff Macklem acknowledged that monetary policy cannot offset the shock of sharply increasing costs,” Rocca added. “New housing development — already in short supply in our major cities — will slow further or grind to halt.”

Calling the potential trade war “a wake-up call,” Rocca argued that governments need to minimize the impact of a tariff battle on the housing sector, cut development charges by 75 per cent, reduce red tape and do more to attract both domestic and international investment, “whether or not tariffs materialize.”

National Bank economists Taylor Schleich, Ethan Currie and Warren Lovely unpack the BoC’s challenge in a tariff scenario of potentially dealing with both inflation and an economic slowdown. Macklem’s acknowledgement that the tariff threat played into the decision to cut today “suggests that they do judge the GDP risks as more important to address,” they write.

The economists say they expect the BoC “to somewhat look through tariff-led inflation and instead provide accommodation to help cushion the damaged economy,” but noted that “inflation pressure would likely limit the amount of rate relief they can provide.”

During today’s announcement, BoC deputy governor Carolyn Rogers traced out the mechanics of inflation pressure, noting that price increases brought on by tariffs “can reverberate, just like we saw things reverberate in COVID.”

“So that’s exactly the scenario that we would be wanting to guard against, and why we would need to react if inflation takes off, if the inflation forces are stronger than the downward forces on growth,” she said, “and then it seems clear what we would need to do.”

CIBC’s top economists say the Bank of Canada is “not too sure, for good reason” when it comes to future policy moves.

“The cross currents on the economic outlook are clouded enough that the Bank eschewed any clear message about its plans for future moves,” Avery Shenfeld and Andrew Grantham wrote in a research note following the decision on Wedensday to cut rates by 25 basis points.

“While there’s a risk of some pauses along the way if any of the growth or inflation data show an uptick, we’re sticking with our call for the overnight rate to reach 2.25 per cent, even in the absence of a trade war.”

In a note to investors, TD economist James Orlando says today’s smaller cut makes sense given inflation is under control and Canada’s economy is showing signs of strength. The slower pace “mitigates the risk” of the BoC’s rate diverging too much from that of the U.S. Federal Reserve, an important consideration given the loonie’s fragility.

TD’s baseline forecast, which does not factor in tariffs, is for the policy rate to hit 2.25 per cent by the end of 2025, Orlando writes. “We are still hopeful that tariff threats are more of a negotiation tactic, meaning they would be temporary and carry less long term impacts. Yet, this is a tail risk that remains front and center in the mind of the BoC.”

In the event of a major trade war that lasts longer than a few months, TD would “expect the central bank to cut more aggressively in order to cushion the economy,” Orlando says.

BoC Governor Tiff Macklem discussed his weekend plans at a press conference in Ottawa on Wednesday.

He told reporters he will be “watching the news” this Saturday, the date U.S. President Donald Trump has given for the start of U.S. tariffs on Canadian imports.

“I will be watching the news very closely, as I imagine most people in the room will,” he said.

“We’re going to have to make our decisions in real-time as developments unfold.”

Macklem says the loonie’s weakness against the U.S. dollar has not limited the Bank’s capacity to lower its policy rate.

“Has the movement in the Canada-U.S. exchange rate constrained our monetary policy decisions to this point? The answer is, no,” Macklem told reporters on Wednesday.

“The depreciation we’ve seen in the Canadian dollar has been more driven, in our view, by trade uncertainty, and particularly President Trump’s threat to impose 25 per cent tariffs on Canadian exports.”

Macklem issued a reminder on Wednesday that the Bank does not directly target exchange rates with its policy decisions.

The BoC’s January Monetary Policy Report assumes a US$0.70 Canadian dollar. The loonie has remained more stable against a basket of other currencies.

“Obviously, the bigger the movements in the Canadian dollar, the more we’re going to have to take those into account as we set policy going forward,” Macklem added.

A major increase in tariffs would push prices up and cause inflation to rise, Macklem notes. The BoC’s focus, he says will be to make sure “this shock does not create persistently higher inflation.”

Because interest rate changes take time to have an impact, “there’s not much we can do” about the initial spike in prices, Macklem says.

“What we don’t want to see, though, is that initial price-level increase starts to feed through broadly to other prices and wages and then becomes persistent inflation. So that is a key thing that we will be focused on preventing. You know, inflation will go up, but we want to make sure it comes back down to 2per cent.”

The language in the BoC’s scenario analysis of tariff impacts makes it clear a recession is expected in the event of heavy tariffs, writes Desjardins Group economist Royce Mendes. The scale of consequent price increases, furthermore, “shouldn’t be enough to stop the central bank from responding to the economic weakness with lower interest rates,” Mendes writes.

In a 25 per cent tariff scenario, Desjardins forecasts the overnight rate dropping to “about 1.5 per cent,” Mendes says. “That’s less than the typical 300-400 basis points of easing necessary to revive the economy from a recession. While we think Canadian officials can largely look through any trade war-induced inflation, they can’t completely ignore it. As a result, the economic recovery from lasting tariffs should be expected to be less V-shaped than typical.”

If tariffs were closer to 10 per cent, with some exclusions, Desjardins sees the overnight rate dropping to around 2.25 per cent, Mendes says.

A tariff scenario notwithstanding, it would take one or two more months of strong jobs data to deter the Bank of Canada from making further rate cuts, says Ashish Dewan, an investment strategist at Vanguard Canada, in comments sent to Yahoo Finance Canada.

Vanguard expects the overnight rate to drop to 2.5 per cent this year, unless a trade war emerges.

“Were the U.S. to implement tariffs of 25 per cent on Canadian goods and Canada then implements 25 per cent tariffs on U.S. goods, we would expect a significant drop in Canada’s growth and a pickup in inflation significant enough that the BoC would need to reverse course and raise interest rates,” Dewan wrote.

Canada’s central bank says U.S. President Donald Trump’s plan to hit Canadian imports with a 25 per cent tariff would result in a 2.5 percentage point hit to average annual GDP growth in its first year.

“In the second year, it is about 1.5 percentage points lower,” Bank officials wrote in their January Monetary Policy Report released on Wednesday. “By the third year, GDP growth has roughly returned to normal.”

Last week, a report from CIBC estimated sweeping tariffs imposed by the U.S. could cost the Canadian economy as much as 3.25 per cent, even after factoring in possible exemptions for the oil and gas sector.

In a statement sent to Yahoo Finance Canada, Meridian’s Paul Shelestowsky writes that “Canada needs today’s cut — and likely future cuts in the next few months — to maintain price stability, boost growth and protect the financial health of Canadian borrowers.”

Inflation is under control, Shelestowsky says, “but with the federal tax holiday ending, and with a potential tariff war looming, the Bank of Canada still has a lot of work to do to ensure Canada’s financial health remains stable in 2025.”