Canada's economic landscape is poised for significant shifts as trade tensions with the United States escalate. According to BMO Capital Markets, the central bank is expected to cut interest rates aggressively in response to the economic strain brought on by new tariffs. This move could push rates to levels not seen in nearly three decades.

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The Beginning of a New Economic Phase

A trade war between Canada and the United States officially began this past weekend, with the U.S. government imposing a 25% tariff on all Canadian goods. The only exception is energy, which will face a 10% tariff. These measures are set to take effect on Tuesday, with potential for further escalation depending on Canada’s response.

In retaliation, Canada has announced a targeted approach, imposing a 25% tariff on $155 billion worth of U.S. imports. An initial $30 billion worth of goods will be affected immediately, with the remaining tariffs set to take effect over the next 21 days. Additional non-tariff measures, including restrictions on U.S. products in Crown-owned stores, are also expected to impact trade relations.

The economic impact of these measures is already being evaluated. BMO analysts forecast an increase in the Consumer Price Index (CPI) of nearly one percentage point this year, alongside a rise in the unemployment rate to 8%. These figures represent a significant shift from previous projections and suggest a need for substantial economic intervention.

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Bank of Canada Expected to Cut Rates More Aggressively

Despite earlier indications that inflationary risks were temporary, the Bank of Canada proceeded with an interest rate cut last week. BMO now expects the central bank to take an even more aggressive approach.

“Previously, we expected the Bank to cut two more times this year, leaving the terminal rate at 2.50%. Now, we’re forecasting 25 basis point cuts at each meeting until October, pulling the terminal rate 100 basis points lower to 1.50%,” said BMO economist Shelly Kaushik.

This downward shift in interest rates would push the Canada-U.S. overnight rate spread beyond -225 basis points, potentially matching the extreme levels observed in 1997.

The terminal interest rate, which represents the expected end point of the central bank’s monetary cycle, is crucial in determining how much easing is required to bring inflation within the target range.

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Canada’s Inflation Model and Its Impact on Monetary Policy

Canada's approach to inflation measurement differs significantly from that of other nations. The exclusion of borrowing costs from inflation calculations means that changes in interest rates do not directly affect CPI in the same way they do in other countries.

Unlike traditional models, Canada’s inflation measurement considers borrowing costs separately from the cost of goods and services. This unique methodology allows inflation to appear more stable even when monetary policy is actively influencing demand and pricing.

Due to this model, Canada is more likely to see rapid shifts in inflation rates when interest rates are cut, reinforcing the central bank’s need to act decisively in the face of economic uncertainty.

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Market Outlook and Next Steps

Leaders from both Canada and the United States are set to meet today in an attempt to address the escalating trade conflict. The outcome of these discussions will play a key role in determining whether the situation stabilizes or deteriorates further.

For Canadian businesses and homeowners, the prospect of lower interest rates may provide relief in terms of borrowing costs. However, the broader economic implications of a prolonged trade dispute remain uncertain.

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