An Understandable Hold But Cracks Suggest Cuts Coming

Last week, the Bank of Canada held its policy rate steady at 2.75 percent. Although headline inflation has been at or below target for nine of the last 11 months, there are some signs of underlying upward pressure on inflation. Also, Canada’s economic performance has been more resilient than expected, so the decision made sense.

However, some cracks are showing, and the next few months will be telling.

We have argued on many occasions that the data the Bank of Canada receives often tells contradictory stories. The Bank must also account for long and variable lags in the effects of its policies.

This lagged effect is important to understand, and we would make the case that while holding made sense now, more rate cuts remain the most likely outcome as we look ahead. Given the lags, the Bank should implement these cuts sooner rather than later.

First, let’s break down the case to hold steady. The Bank’s preferred measures of core inflation, which strip out the more volatile inflation components like energy, and which supposedly capture the trend in price changes, have remained elevated, stubbornly sitting around 3 percent since the beginning of the year. GDP growth has continued to surprise on the upside, and the word “resilience” has been bandied about. In the first quarter of 2025, GDP growth was 2.2 percent, significantly outpacing the Bank’s 1.8 percent forecast. Lastly, although economists expected a flat jobs report in June, the economy created more than 80,000 and the unemployment rate ticked down.

But we think there are reasons to question the economy’s true resilience. Let’s look at these in the reverse order that we listed the reasons to hold.

On jobs, more than 80,000 were created, but gains were dominated by part-time jobs, which increased by 70,000, and the July number released today showed a loss of 40,000 jobs. The results of the Bank’s most recent Business Outlook Survey  suggest that businesses are now placing less weight on the worst-case scenario for the tariff situation. However, uncertainty is still driving their decisions relative to hiring and investment. The majority of firms plan to keep staffing levels where they are and plan no significant investment beyond maintenance of their existing productive capacity.

Weak hiring and investment will slow GDP growth. So will a fall in exports, in particular to the United States. Exports were strong in the early months of 2025 despite the on-again, off-again tariff threats, but this appears to have been the result of Americans front-running more permanent increases in prices of goods and services bought from Canadian businesses. Exports have fallen 27 percent since their January peak. This will feed through to the rest of the economy, and Donald Trump’s grand pronouncement of 35-percent tariffs last Thursday will further harm goods not covered by the Canada-United States-Mexico Agreement.

The last crack – and perhaps the most important one given the Bank’s mandate – is the stubbornness of core inflation. In addition to the 3 and 3.1 percent reading in June for the two main core measures, CPI-trim and CPI-median, year-over-year increases in more than 40 percent of CPI components are above 3 percent. However, as business investment weakens and consumer confidence continues to worsen (as it did in the Bank’s most recent Canadian Survey of Consumer Expectations) consumer spending will slow, driving core inflation down.

The core inflation measures are supposed to be good indicators of where inflation is headed over the medium term. However, they have been poor predictors over at least the past year. As inflation came down, the core measures increased, and the divergence between headline inflation (1.9 percent in June) and the two core measures has been more than a full percentage point for three months.

The decision to hold steady was understandable. Despite some signs of resilience in the Canadian economy, however, we don’t believe it will last much longer. Cracks are beginning to show. More rate cuts are coming. Given the lag between changes in monetary policy and their impact on the economy, it is important for the Bank of Canada to make these cuts in timely fashion.

Jeremy M. Kronick is vice-president and director of the Centre on Financial and Monetary Policy at the C.D. Howe Institute, where Steve Ambler, a professor of economics at Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy.