The Bank of Canada is locked into a “wait-and-see” holding pattern while it navigates a slowing economy and rising oil-driven inflation risks, says an economist.
The central bank held its benchmark interest rate at 2.25 per cent on Wednesday with Governor Tiff Macklem stating that economic weakness and rising inflation pose a dilemma for central banks.
“The word dilemma is an important word,” says Earl Davis, head of fixed income and money markets at BMO Global Asset Management.
“To me that says unchanged rates for the balance of 2026.”
The central bank stated that near-term growth looks weaker than expected, and the Canada-United States-Mexico Agreement (CUSMA) is a significant unknown. Meanwhile, risks to inflation are tilted to the upside because of the sharp increase in energy prices. On top of that, Canada’s financial future is muddy because of big structural changes like AI adopting and shifting demographics.
According to Davis, that uncertainty is making it difficult for the Bank to justify either cutting or raising rates.
“We’ve got so many things on both sides of the choice of easing or hiking, that’s why we believe they will remain unchanged for the balance of the year,” he says.
Oil becomes the key variable
While Canada’s economy slipped into a technical recession in the first quarter, the bank is also monitoring inflation risks stemming from higher energy prices resulting from the war in Iran, says Davis.
The price of Brent crude oil was US$92.43 a barrel on Wednesday morning after U.S. President Donald Trump warned Iran that they will “pay the price” for dragging out peace negotiations to end the war.
“I think that the US$90 level for oil is an important pivot point,” says Davis.
“The further below US$90 that we go definitely maintains rates where we are. If we go below US$80, I think there’s eases back on the table. Above US$90, they want to maintain their optionality, and I think above US$$100 you know, hikes are definitely a stronger possibility.”
The central bank noted there has been limited evidence that higher energy prices are feeding through to broader inflation, but Davis warned that could change if the conflict drags on.
“If there is no resolution to the Iran-U.S. crisis slash war, what happens is there’s nonlinear effects on inflation. It means inflation spikes. It doesn’t just rise gradually,” he says.
“The expectation would be, the pass through would come through if there’s no resolution by August, and that’s where the risk is from the Bank of Canada.”
Davis says countries have so far been relying on oil reserves to help cushion consumers from higher prices, but those stockpiles are being depleted.
“We’re coming very close to those oil reserves running out,” he says.
“Once they run out, that’s when you see a jump in oil prices.”
Growth concerns remain
While Canada recently posted a stronger-than-expected employment report, Davis says it remains unclear whether the labour market has stabilized.
“We’ll have to see the next couple of months of employment, whether there is a maintenance of the, you know, the 6.6 level or whether that declines again,” he says.
Some economists have suggested hiring tied to tourism and World Cup activity may have contributed to the stronger jobs data, and although the employment report was “a positive number,” policymakers will need to assess the trend over several months, he says.
He highlighted that the central bank expects the economy to remain in excess supply. While this may not immediately impact the economy, it slows down investment because large international companies are holding back on putting significant capital into Canada due to uncertainty surrounding the future trading relationship with the U.S. under CUSMA.
“Excess supply is the counter wind or head wind to inflation. It helps keep inflation lower, helps lower the pass through,” Davis says.
“Again, this says why they’re in that dilemma.”
The Fed also matters
Davis says policymakers in Canada will also be watching the U.S. Federal Reserve.
While the Fed is not expected to change interest rates at its next meeting, any shift in its policy outlook could “ most definitely” influence the Bank of Canada through the exchange rate and inflation, says Davis.
“It has an impact on the currency in regards to looking at interest rate differentials, and our currency does impact our exports, does impact inflation,” says Davis.
He also notes that markets have shifted their expectations for U.S. rates as employment data south of the border has remained resilient.
“With the strong employment number that we’ve seen last week, if that continues, it’s going to be very difficult for them to maintain their easing bias,” he says.
“The market is actually discounting hikes in the U.S. now.”
