Bank of Canada Cuts Interest Rates Amid Growing U.S. Trade Uncertainty

The Bank of Canada (BoC) has cut its policy rate by 25 basis points, bringing the benchmark interest rate down to 3.0%. While this move was widely anticipated, the central bank’s focus in its accompanying statements was less about the present state of the Canadian economy and more about the looming uncertainty surrounding potential U.S. tariffs. With former U.S. President Donald Trump set to reintroduce blanket tariffs on Canadian and Mexican goods starting February 1, the BoC is grappling with a complex economic landscape where the usual rules of monetary policy may not apply.

Before factoring in the tariff threat, the BoC had a relatively strong handle on the Canadian economy’s trajectory. Inflation has stabilized within the BoC’s target range, growth—while slow—is improving, and unemployment remains near its peak. With 200 basis points of rate cuts already in place, the BoC had been expected to gradually lower rates towards 2% by the end of 2025. However, the uncertainty surrounding U.S. trade policy has thrown a wrench into this outlook.

Governor Tiff Macklem and the BoC’s Monetary Policy Report both emphasized that the economic outlook is clouded by unknowns, stating that Canada is "missing too many pieces of information to know exactly what a trade war means for the country." While the direct impact of tariffs on trade and GDP is hard to quantify at this stage, the mere threat of tariffs has already started affecting business confidence, investment decisions, and financial markets.

The word “uncertainty” appears 42 times in the BoC’s latest report—an indication of just how precarious the situation is. While the central bank has historically framed monetary policy adjustments as akin to navigating a dark room, the current environment resembles an even more challenging scenario—one where policymakers are blindfolded while dodging unpredictable external shocks.

Governor Macklem has openly acknowledged that Canada’s policymakers have no way of knowing how severe or prolonged a potential trade conflict could be. Key unknowns include:

• The exact tariffs to be imposed.

• The duration of the trade restrictions.

• Possible retaliatory or fiscal countermeasures from Canada.

Even before the tariffs take effect, the BoC has already revised down its growth forecasts for 2025 and 2026 to 1.8%, a sign that trade uncertainty alone is weighing on economic activity.

One of the key challenges facing the BoC is modeling the potential impact of tariffs on the Canadian economy. A tariff shock is inherently complex, as it introduces both negative growth effects and inflationary pressures. This phenomenon—commonly referred to as "stagflation"—presents a unique policy dilemma. On one hand, tariffs could slow economic growth by limiting exports and increasing costs for Canadian businesses. On the other hand, they could drive up inflation by making imported goods more expensive, especially if Canada responds with retaliatory tariffs.

Governor Macklem made it clear that the BoC’s primary concern remains economic stability, stating, "We are equally concerned about inflation rising above the 2% target or falling below it." This balanced approach suggests that while further rate cuts are likely, their timing and magnitude will depend on how the trade conflict unfolds. If tariffs are imposed and lead to a sharp economic downturn, the BoC may be forced to cut rates more aggressively than currently anticipated.

The BoC has conducted various stress tests to gauge the worst-case scenario. In a severe case—where the U.S. applies a blanket 25% tariff on all trade partners and those nations retaliate—Canada’s real GDP could contract by approximately 2.5 percentage points in the first year of tariffs alone. This would likely push Canada into a recession, a sentiment echoed by multiple economists.

Trade restrictions could also weaken the Canadian dollar, exacerbating inflationary pressures by making imports more expensive. The loonie has already depreciated by over 6% year-over-year, holding above 69 cents USD. As trade uncertainty drags on, further depreciation could be on the horizon.

While monetary policy is a powerful tool, the BoC’s ability to counteract the effects of a trade war is limited. Macklem acknowledged that the central bank cannot simultaneously offset weaker output and higher inflation. However, given that trade wars typically have a longer-lasting negative impact on economic growth, the BoC is likely to prioritize supporting the economy through additional rate cuts rather than attempting to curb inflation spikes caused by tariffs.

BMO chief economist Doug Porter described the BoC’s decision as "battening down the hatches ahead of a possible trade war storm." Money markets currently see a 43% chance of another quarter-point cut at the BoC’s next meeting on March 12. If the tariffs go into effect and persist, rate cuts could exceed market expectations, with some analysts predicting a potential drop to 2.25% by year-end.

With just days to go before the February 1 tariff deadline, all eyes are on the White House. While the BoC has taken a proactive approach by preemptively cutting rates, the true test will come if and when tariffs are imposed. Macklem summed up the central bank’s approach succinctly: "I will be watching the news very closely."

As Canada braces for potential economic turbulence, businesses and consumers alike must prepare for a period of heightened uncertainty. The BoC stands ready to act, but the extent of its intervention will ultimately be dictated by the scale and duration of U.S. trade policies. For now, cautious optimism remains, but the risk of a sharp economic downturn cannot be ignored.