Published in the The Globe and Mail.
The Bank of Canada held its policy rate constant at 2.25 per cent on Wednesday, meeting market expectations. This was despite headline inflation increasing to 3.2 per cent in May, up from 2.8 per cent in April. This is outside the Bank of Canada’s 1-to-3 per cent 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 per cent, in 2021, it eventually made its way to 8 per cent. But the situations are not the same. Leaving the overnight rate target at 2.25 per cent was the right call for the bank, and if anything, we might need a cut before we see a hike.
In March, 2021, headline inflation was 2.2 per cent, just north of 2 per cent. A month later, it rose to 3.4 per cent.
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 per cent by July and August, up from 2.4 and 2.3 per cent respectively in March, 2021.
This time around, core inflation has been decreasing, with CPI-trim at exactly 2 per cent and CPI-median at 2.1 per cent. 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 per cent, 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 per cent sufficient? At 2.25 per cent, we are at the low end of the bank’s estimated range for the “neutral rate” (2.25 to 3.25 per cent), 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 per cent of Canadian companies have reduced, paused or cancelled capital expenditures, and 42 per cent have scaled back or paused R&D 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 due to 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 by 1.7 per cent in May. The total value of investment in construction increased by 2.3 per cent 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 per cent and headline inflation above 3 per cent, a cut wasn’t on the table.
Jeremy 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.