Tariffs and the Price of Money

When the Bank of Canada releases its interest rate decision next week, it will be doing so under a cloud of trade uncertainty. More than a month before President-elect Trump is set to be inaugurated, he’s already roiling global markets by threatening to slap Canada and Mexico with 25% tariffs and China with an additional 10% levy over and above what’s already in place.

Businesses are already taking action. Reports from Canada to China suggest that firms are frontloading exports to US buyers in an attempt to avoid potential tariffs. That’s building up the resilience of global supply chains so that any sudden change in US trade policy can at least temporarily be weathered. It’s also boosting the exports of these countries.

Our economists have upgraded their GDP growth forecasts for Canada next year as US importers look to stockpile goods sourced from across the border. Of course, the flip side of such a change is that our team has lowered its view of 2026. While monetary policymakers will be tasked with navigating that choppy growth outlook, they’ll also need to think about the impacts of tariffs on consumer prices.

Typically, central banks try to look through one-time price level shifts, instead focusing on the underlying inflation rate. In theory, tariffs and retaliatory actions only affect prices once, so protectionism would seem to engender only one-time price increases. The question is whether the central bank is willing to bet all its chips on the theory that tariffs don’t have any lasting impact on the pace of inflation.

The Bank of Canada recently said that one of the main reasons inflation returned to the 2% target post-COVID is that monetary policymakers were successful in keeping inflation expectations anchored around 2%. While it’s true that the greater the magnitude of tariffs Canada faces, the greater the likelihood of more rate cuts, we don’t view it as a linear relationship. The more retaliatory tariffs are placed on American goods, the greater the increase in Canadian consumer prices and, as a result, the greater the threat to inflation expectations.

What’s more, rewiring global trade, as Donald Trump wants to do, will also weigh on productivity. In lowering the non-inflationary speed limits of economies around the world, protectionism will raise the prospect of unwanted inflation. Central banks still don’t have models that can accurately forecast the supply sides of economies, even after facing massive supply shocks during the pandemic. With the magnitude of any increase in price pressures as a result of rewiring global trade unknown, an extra degree of caution on aggressive rate cutting is warranted.

Our analysis shows the Bank of Canada cutting rates more under more severe levies. But the most bullish bond investors may still be disappointed at how little we see the central bankers cutting rates over and above our base case forecast, particularly if a weaker loonie offsets some of the costs of tariffs for US consumers.