In line with market expectations, the Bank of Canada (BoC) kept its policy rate at 2.25% on Wednesday. This marks the sixth consecutive status quo for the central bank, which is grappling with an economy operating below its potential and inflation exacerbated by the conflict in the Middle East.
In its latest decision, the BoC offers a glimmer of hope: the pressures resulting from US trade policy appear to be easing, and growth is beginning to pick up after a year of stagnation. Policymakers say they are increasingly confident about this economic recovery, despite the uncertainty that continues to prevail.
“After stalling over the past year, economic growth looks to have resumed in Canada,” Governor Tiff Macklem said in opening remarks. “The data we’ve been receiving since April reassure us that the economy is indeed weathering this period of global upheaval.”
The decision announced on Wednesday coincides with the release of the Monetary Policy Report. Here are some highlights:
- Global growth has been revised downward to 2.8% in 2026 (from 3.0% previously) but revised upward to 3.2% in 2027.
- In Canada, real GDP growth is projected to reach 0.7% in 2026, down from the previous forecast of 1.2%.
- The 2027 outlook has been revised slightly upward, with growth now expected to be 1.8%, up from 1.6% previously.
- The contribution of consumption to growth rose to 0.9 percentage points, but housing and government spending brought the total contribution from domestic demand to 1.4 points, down from 1.7 points previously.
- CPI inflation for 2026 has been revised upward to 2.5% (from 2.3%), but prices are expected to stabilize as early as 2027.
- The BoC expects inflation to reach 2.5% in Q3 2026, followed by 2.2% in Q4, while core inflation is already close to the 2% target.
- Annualized quarterly GDP growth is expected to reach 2.5% in the short term before slowing to 1.5% in Q3 2026.
Our Observations
Beyond Cyclical Data
We agree with the Bank of Canada’s view that the Canadian economy is strengthening. Recent data point to improving momentum, including a 17% annualized increase in real shipments during the second quarter, stronger motor vehicle sales, and a significant expected contribution from trade to GDP growth. Together, these indicators suggest that economic activity is accelerating and that growth is becoming more broadly based.
However, we disagree with the BoC’s assessment that the labour market is characterized by excess supply. In our view, it relies too heavily on cyclical indicators such as the unemployment rate while paying insufficient attention to structural forces shaping the labour market. Looking only at short-term indicators provides an incomplete picture of underlying labour market conditions.
The truth is the following: the ratio of Canadians aged 15 to 64 relative to the total adult population continues to decline and is now close to 76%. This means a smaller share of the population is available to work and support economic activity. At the same time, Canada faces roughly 300,000 retirements annually, while labour force growth is slowing. These trends are difficult to reconcile with the idea of a large excess supply of labour.
We believe the BoC’s analysis assumes that most unemployment fluctuations are cyclical and temporary. In contrast, structural issues may be playing a much larger role. These include workforce aging, labour shortages in specific sectors, skills mismatches, slowing labour force growth, and weaker immigration growth compared with previous years. Such factors can limit labour supply even when unemployment rates appear elevated.
The combination of large retirements, extremely low participation among older workers, and a shrinking working-age population share creates what we see as a significant labour supply challenge. Evidence of these pressures can be found in wage growth among workers aged 55 and over, which has returned to levels last seen during the inflation surge of 2023. We therefore believe labour market conditions may be tighter than suggested by traditional indicators.
We also question the BoC’s conclusion that wage pressures are largely under control. While some measures show wage growth around 2.7%, we believe focusing on a limited set of indicators risks understating broader wage pressures. As a result, we view the Bank’s labour market assessment as incomplete and not fully aligned with the broader data.
We are also skeptical of the BoC’s assumption that trend productivity growth has improved and will remain strong throughout the forecast horizon. After several years of weak productivity performance, we see little evidence of a sustained turnaround. If productivity growth remains weaker than assumed, the economy’s potential growth rate may be lower and inflationary pressures may be stronger than expected.
Finally, we place less importance on the output gap than the BoC does. Although it estimates modest excess supply in the economy, we believe the output gap has only a limited effect on inflation. The more important factor is the evolution of costs, particularly wages relative to productivity. It is not because you don’t see this in inflation that it is not there, especially when inflation is distorted by some relative price shocks.
As a result, our base-case scenario differs from the BoC’s. Rather than expecting inflation to smoothly converge to 2%, we see a meaningful risk of core reflation, driven by structural labour shortages, persistent wage pressures, and weak productivity growth.