The Bank of Canada is Right to Tread Water on Interest Rates

From: Jeremy M. Kronick and Steve Ambler 

To: Interest rate watchers 

Date: July 22, 2026 

Re: The Bank of Canada is Right to Tread Water on Interest Rates

The Bank of Canada held its policy rate constant at 2.25 percent last week, meeting market expectations. This was despite headline inflation increasing to 3.2 percent in May, up from 2.8 percent in April. This is outside the Bank of Canada’s 1 to 3-percent control range.

The instinct, looking at these inflation numbers, would be to hike. This is especially true when one considers that the last time inflation jumped above 3 percent, in 2021, it eventually made its way to 8 percent. But the situations are not the same. Leaving the overnight rate target at 2.25 percent was the right call for the Bank, validated Monday when the June number showed a drop back to April’s 2.8 percent. And, if anything, we might need a cut before we see a hike.

In March 2021, headline inflation was 2.2 percent, just north of 2 percent. A month later, it rose to 3.4 percent.

Back then, core inflation measures (CPI-trim and CPI-median), which exclude volatile and idiosyncratic components of the consumer price index, were also on the rise, going beyond 3 percent by July and August, up from 2.4 and 2.3 percent respectively in March 2021.

This time around, core inflation has been decreasing, with CPI-trim down to 2 percent and CPI-median at 2.1 percent in May. (They were down further in June, according to Monday’s announcement, to 1.8 and 1.9 percent respectively.)

This makes it easier for the Bank to argue, as it did in its announcement, that the spike in oil prices is the primary driver of headline inflation above 3 percent, that it has not spread to other sectors, and is therefore temporary.

Of course, the situation in the Middle East changes from day to day, or even several times a day, so we will see how long this argument holds, but for now it is on safe ground.

On the other side, while gross domestic product rebounded in April after a poor showing in the first quarter of 2026, there are still concerns about the Canadian economy. First, the jump in April was from a level below where GDP was last September. Second, job gains in April and May were still not enough to entirely close the gap from the decline in employment since the beginning of the year.

It is, therefore, not surprising that the Bank continues to talk about excess capacity in the economy.

If this is the case, and more stimulus is needed, is an overnight rate target of 2.25 percent sufficient? At 2.25 percent, this is at the low end of the Bank’s estimated range for the “neutral rate” (2.25 to 3.25 percent), the rate compatible with inflation at target and the economy at full capacity. So, at first blush, the answer should be yes.

But there is evidence that normally interest-sensitive sectors, such as construction and manufacturing, are not responding to the degree we would expect. A recent survey by KPMG showed that 57 percent of Canadian companies have reduced, paused or cancelled capital expenditures, and 42 percent have scaled back or paused research and development investment.

According to the Bank’s Business Outlook Survey published on July 6, the only sector showing strong investment intentions was oil and gas, no doubt boosted by the spike in commodity prices because of the Iran war.

The housing sector is also in the doldrums. Despite new government policies, housing starts have not taken off. The value of new building permits fell in May by 1.7 percent. The total value of investment in construction increased by 2.3 percent in April, but at $23.6-billion it is well below its 2021 level (in constant dollars).

Overall, there is a case to cut the overnight rate further to stimulate more demand.

The challenge, however, is determining how much of the excess capacity is truly cyclical. If the issues are more structural – and there is evidence to suggest they may be – the excess capacity we discussed could disappear, as the economy’s potential would be lower than the Bank believes. In that case, lowering the overnight rate would stimulate demand, but at the risk of spiking inflation.

The Bank will have to determine whether it is seeing cyclical or structural issues when deciding whether a cut to the overnight rate is needed. But, for now, with short-run inflation expectations above 2 percent and headline inflation where it is, a cut wasn’t on the table.

Jeremy M. Kronick is president and chief executive at the C.D. Howe Institute, where Steve Ambler, emeritus professor of economics at Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy.

To send a comment or leave feedback, email us at blog@cdhowe.org.  

The views expressed here are those of the authors. The C.D. Howe Institute does not take corporate positions on policy matters.  

A version of this Memo first in The Globe and Mail.