Canada’s facing a trade war with its largest partner, and it may send interest rates plunging. BMO Capital Markets wrote to investors after the first round of tariffs were announced this weekend. The bank now expects rates to be slashed much more aggressively, trimming another point off the bottom for overnight rates. The plunge would test the historic extremes for rapid easing set nearly 30 years ago.
The Canada-US Trade War Is Set To Begin Next Week
Canada and the US kicked off its trade war this weekend. The US administration unveiled a 25% broad tariff on all goods from Canada, with a 10% tariff on energy being the only exception. It’s set to go into effect on Tuesday, with the country emphasizing it will adopt additional measures if Canada responds.
Canada’s response was smaller and more targeted. The country will hit them with a 25% tariff on $155 billion in US imports, with $30 billion in categories going into effect on the same date. The rest are set to go into effect 21 days later. Non-tariff measures such as removing US products from Crown-owned stores are expected to have an additional impact.
The hit to Canada’s GDP has been discussed frequently over the past few weeks, but BMO outlined more specific expectations for inflation and unemployment. The bank sees CPI adding a little under a point this year, and the unemployment rate rising to 8%, adding a point to its previous forecast sans tariffs.
That’s going to require a lot of stimulus.
Canadian Interest Rates May Plunge Further Than Thought
Last week, the central bank slashed rates despite noting inflation risks and low CPI being temporary. A shift that means the central bank is no longer addressing its concrete issues, but in full panic mode. “Note that the Bank of Canada’s cut last week was partially viewed as a risk management move to guard against, well, this situation,” explained Shelly Kaushik, an economist at BMO.
BMO now sees the central bank slashing rates much more aggressively on this path. “Previously, we expected the Bank to cut two more times this year, leaving the terminal rate at 2.50%. Now, we’re forecasting 25 bp cuts at each meeting until October, pulling terminal 100 bps lower to 1.50%,” she forecasts.
Adding, “This means Canada-U.S. overnight rate spreads will push past -225 bps, testing the all-time extreme from 1997.”
The terminal interest rate is when central banks are projected to end their monetary cycle. In this case, it’s the amount of ease believed to bring the inflation rate to target.
Canada’s Circular Inflation Model Means Atypical Response
Canada’s unique CPI methodology plays a role here. Since the cost of borrowing is heavily influenced by the rate of inflation, components heavily influenced by borrowing aren’t included. Borrowing costs aren’t the cost of goods or services, but the annualized cost of capital to purchase those items. Since cheap credit is designed to raise demand and therefore cost, it’s already priced in. Including financing rates places extra downward pressure on CPI. However, it would only register as deflation to those who think breaking up a $100 payment into 4x easy $30 monthly installments, means falling prices.
Canada is one of the only countries to use this infomercial-style inflation model. As a result, its model is less about actual prices than other countries and circularly reports. By cutting rates, inflation falls immediately—the price of nothing else has to fall and demand doesn’t have to increase. It’s more of a circle jerk than anything, so Canada is so much more “effective” at CPI control. It isn’t measuring the same thing. Not by a long shot. But that’s how it works! And that is also why Canadian policymakers are less likely to respond like other countries engaged in traditional monetary policy.
Both Canadian and US leaders are scheduled to meet later today. It’s unclear if they can promptly agree and mitigate the most drastic shock. If they do, the outlook will likely shift again—though it will almost certainly have eroded from the pre-tariffs discussion.