As widely expected, the Bank of Canada (BoC) kept its policy rate at 2.25% on Wednesday. The central bank also opted for the status quo at its last four meetings.
Rising energy prices and disruptions to the global supply chain resulting from the war in Iran are weighing on economic growth and fuelling inflation. At the same time, the US administration keeps suggesting new tariffs, and uncertainty surrounding trade policy remains high. The Bank of Canada is assessing the short-term impact of these developments on core inflation, but it will not allow rising energy prices to “become broad-based persistent inflation.”
In an opening statement, Governor Tiff Macklem explained that “economic weakness combined with rising inflation is a dilemma for monetary policy.” He pointed out that raising rates to curb inflation could further weaken the economy, while lowering them to support growth would increase the risk of high and persistent inflation. “For now, holding the policy rate unchanged balances those risks,” he concluded.
Here are a few remarks made by the Bank of Canada following its June 10 decision:
- Financial conditions in Canada have eased since the release of the Monetary Policy Report in April.
- The job market strengthened in May, and the unemployment rate fell to 6.6%.
- Inflation, as measured by the consumer price index (CPI), rose to 2.8% in April.
- Measures of core inflation have stabilized around 2%, and the share of CPI components is approaching its historical average.
- Activity in the housing market also declined, and business investment remained low.
Our observations
The Bank of Canada characterizes the Canadian economy as being in excess supply and expects inflation pressures to remain contained, aside from temporary increases driven by higher energy prices. These assessments, however, appear to be based on misinterpretations of both demand and supply dynamics.
On the demand side, while real GDP has been relatively flat over the past year, consumption tells a different story. Real consumption has grown at an average quarterly pace of 2% over the past four quarters, above its long-term trend. Service consumption, an important GDP component unaffected by tariffs, has grown above 3% per quarter in the last year. The weakness in Canadian GDP largely reflects a series of specific, temporary shocks, including tariffs and fluctuations in government spending. In addition, strong wealth effects and historically elevated household deposits point to healthy balance sheets and sustained consumption momentum, which the Bank itself expects to continue. This makes the excess supply narrative increasingly difficult to justify.
On the supply side, the Bank’s assessment relies heavily on unobserved data and misestimated potential output. It assumed that recent record immigration flows would translate immediately into labour supply, ignoring skill mismatches and gradual labour market integration. As a result, supply has been overestimated. Evidence suggests domestic demand has surged while supply has been constrained by weak productivity growth and fewer hours worked than expected.
Regarding inflation, the Bank emphasizes energy-driven headline inflation while downplaying underlying pressures. It notably avoids discussing wage growth and productivity, despite wages rising well above levels consistent with stable inflation and productivity continuing to contract. Core inflation has been temporarily contaminated by relative price shocks and base-year effects.
Overall, persistent wage-cost pressures, weak productivity, and stable margins suggest rising core inflation will become the dominant concern, ultimately forcing the Bank to normalize its monetary policy toward the upper band of the neutral zone.