Considerations for monetary policy
Governing Council members discussed the risks around the base-case projection, which they viewed as reasonably balanced, apart from the possible imposition of wide-ranging tariffs.
In terms of GDP growth, some members highlighted the risk that consumer spending could be stronger than in the January MPR projection due to the high savings rate and lower interest rates. A boost to consumer demand could put upward pressure on inflation. If some of the savings flowed into housing activity, it could push up already elevated inflation for shelter prices. Members expected house prices to increase, but there was no evidence thus far that price increases were accelerating.
Members viewed the impact of prolonged trade uncertainty on business investment and consumer confidence as the main downside risk to the outlook. They discussed this at length. Even if no tariffs were imposed, a long period of uncertainty under the cloud of tariff threats would almost certainly damage business investment in Canada. Members discussed recent survey results from the Business Leaders’ Pulse and anecdotal information that indicated that some businesses were considering shifting investment to the United States. This would likely lead to negative effects on hiring, labour income and household spending.
Governing Council then spent considerable time discussing the channels through which a protracted trade conflict with the United States would affect output and inflation, and the implications for monetary policy.
Members acknowledged that it was impossible to predict what would happen with US trade policy.
Nonetheless, it was clear that a protracted trade conflict would lead to a decline in economic activity. GDP would be lower in both Canada and the United States, but the GDP loss would be significantly larger for Canada because Canada has a more open economy, and its exports are so concentrated with the United States. Governing Council members also noted that the adverse impact on the level of GDP would be permanent, and the growth of GDP would be reduced until the Canadian economy adjusts to the tariffs.
Members also recognized that retaliatory measures by Canada and other countries in response to tariffs would raise the prices of imported consumer and intermediate goods, which would put upward pressure on inflation. While retaliatory tariffs would likely represent a one-time increase in the level of prices, members noted that, given the size of the shock, there was a risk that higher import prices could feed into other prices. If this leads to an increase in inflation expectations, it could generate higher ongoing inflation.
Governing Council members also noted other possible impacts of tariffs with important implications for Canada:
- A global trade conflict would lower global growth, reducing the demand for energy and likely lowering the global price of oil. This would tend to lower inflation, but it would also reduce incomes in Canada, given the country’s large energy export sector.
- A tariff war could also lead to disruptions in supply chains. With the interconnected nature of manufacturing in Canada and the United States, there is considerable scope for supply chain bottlenecks. The impacts of such disruptions would be hard to predict. This could compound the initial shock from tariffs and feed into inflationary pressures.
- Governing Council members reviewed analysis indicating that the recent depreciation in the Canadian dollar largely reflected trade uncertainty. Tariffs could cause the dollar to depreciate further. The extent of the depreciation would depend on how much markets had already accounted for the impact of tariffs. A lower dollar would partially offset the impact of tariffs on Canadian exports, but it would also raise the cost of imports further.
Members exchanged views on several factors that could affect the dynamics of economic activity and prices if the trade conflict were to be long lasting.
First, the hit to business investment could damage the growth prospects of the Canadian economy. Companies were already re-evaluating their investment plans in the face of trade policy uncertainty. With significant tariffs, the risk of capital flight would increase, exacerbating Canada’s competitiveness challenges and low productivity growth. Members were concerned that US tariffs on Canadian exports would add significant pressures on Canadian exporters. Over time, this could lead to business closures and companies exiting the export sector. In the long run, tariffs introduce inefficiencies that weigh on the productive capacity of an economy—meaning lower productivity and lower potential output than in the absence of the tariffs. Members recognized that monetary policy is not able to offset these longer-term implications of a trade conflict. It would only be able to smooth the path in the short-term as the economy transitions to a lower productivity and lower output trajectory.
Second, they discussed the short-run implications for inflation expectations. During the recent period of high inflation, long-term inflation expectations remained well anchored. However, businesses could quickly pass on higher input costs to their customers by raising prices. Also, given Canadians’ recent experience with high inflation, a one-time increase in the price level of tariffed imports could push up short-term inflation expectations. Members agreed that monetary policy would need to guard against second round effects of any initial price level shock coming from higher inflation expectations.
Third, members discussed the potential fiscal responses to the imposition of broad-based tariffs on Canadian exports to the United States. Monetary policy is a blunt instrument that can only support or restrict demand across the whole economy. Fiscal policy, on the other hand, can be much more targeted, providing a cushion to help hard-hit workers and businesses, and help the economy adjust to long-lasting structural changes brought about by a protracted trade conflict. The impact of fiscal measures on economic activity and inflation would depend on the form, scope and duration of the fiscal response. Members agreed to incorporate new fiscal measures in their analysis as those measures are announced.
Members agreed that in setting monetary policy, they would need to consider the downward pressure on inflation from weakness in the economy and weigh that against the upward pressure on inflation from higher input prices and supply chain disruptions. But with considerable uncertainty about the timing and magnitude of these effects, Governing Council members acknowledged that assessing and balancing the impacts of these forces on output and inflation would be a dynamic process. In other words, in setting monetary policy, they would need to continuously gauge the effects of a trade conflict in real time as new developments unfolded.
Given the high degree of uncertainty, members agreed that they would need to assess a wide range of incoming data on economic activity and prices. This includes information on supply chains and the links between sectors, and more frequent and detailed surveys to generate insights into how businesses and households adjust to the changing landscape.
Overall, Governing Council members agreed that monetary policy cannot offset the long-term economic adjustment that permanent tariffs would cause. And in the short run, monetary policy cannot lean against lower growth and higher inflation at the same time. But having restored low inflation and reduced the policy interest rate substantially, monetary policy is better positioned to help smooth the economy’s adjustment to a tariff shock.
