Navigating Economic Uncertainty: The Canadian Economy in 2025

Introduction: A Shifting Monetary Landscape

The Bank of Canada has initiated a significant shift in its monetary policy stance, most recently cutting the overnight rate to 3.75%. While inflation has moderated to around 2%, excess supply persists in the economy, and unemployment is expected to rise, posing questions about the trajectory of economic recovery. This article explores the economic outlook for Canada through 2025, analyzing policy shifts, inflation dynamics, growth expectations, and the challenges ahead.

"The Bank of Canada finds itself navigating a complex landscape of inflationary pressures, potential economic softening, and geopolitical uncertainties. How well policymakers balance the interests of fostering growth, managing inflation, and responding to global dynamics will shape Canada’s economic landscape in the years to come."

Excess Supply and Labour Market Challenges

The Canadian economy is expected to contend with lingering excess supply until at least 2026, driving unemployment higher to an estimated 8%, up from the current rate of 6.5%. The labor market remains soft, with unemployment rising primarily among newcomers and youth. Despite significant population growth, wage growth has outpaced productivity, maintaining upward pressure on costs. The Bank of Canada faces the challenge of balancing monetary easing while ensuring that inflation stays within its targeted control range of 1-3%.

"The Canadian economy is expected to contend with lingering excess supply until at least 2026, driving unemployment higher to an estimated 8%, up from the current rate of 6.5%."

Future Rate Cuts: A Careful Path Forward

The Bank of Canada's decision to cut rates has been driven by a need to navigate economic headwinds while mitigating inflation risks. The current policy rate remains above the neutral range, signaling that additional cuts may be on the horizon. Another 50 basis point (bps) rate reduction could occur in December, contingent on economic data showing continued signs of weakness. However, there is a growing consensus that subsequent cuts may be smaller, with 25 bps reductions as a more cautious approach, given inflation's uncertainty and the potential for geopolitical risks to influence commodity prices.

"Interest rates may need to drop below the neutral rate range (estimated between 2.25% to 3.25%) to counter the risk of a significant undershoot of inflation targets."

Inflation Targets and Policy Neutrality

Interest rates may need to drop below the neutral rate range (estimated between 2.25% to 3.25%) to counter the risk of a significant undershoot of inflation targets. The Bank of Canada has indicated that inflation should stay close to 2%, but there are concerns that further weakening could require more aggressive rate reductions. The decline in headline inflation from its peak of 8.1% to its current level of 1.6% has been supported by lower energy prices and a broad moderation in price pressures.

While inflation has moderated to around 2%, excess supply persists in the economy, and unemployment is expected to rise, posing questions about the trajectory of economic recovery."

The core measures of inflation, including CPI-median and CPI-trim, have also shown easing, now hovering at 2.3-2.4%. However, shelter inflation remains sticky, as rising mortgage interest costs and elevated rent inflation persist. The need for balance in monetary policy remains evident, with the Bank considering both the risk of inflation overshooting and undershooting its target.

Growth Prospects: An Uneven Recovery

Canada's economic growth is projected to pick up gradually, averaging 2.25% in 2025 and 2026, supported by softer monetary conditions, improved consumer spending, and increased energy exports. The Trans Mountain Expansion pipeline and new liquefied natural gas (LNG) export facilities are expected to bolster energy exports, contributing significantly to growth. Consumer spending, though still below pre-pandemic levels, is likely to improve as the labor market gradually recovers and interest rates decline, reducing borrowing costs.

The projected recovery, however, remains uneven. GDP per capita, which declined throughout 2024, is expected to improve only modestly in 2025. Growth in business investment has slowed, reflecting weak business sentiment, but is expected to recover in line with declining interest rates. Residential investment, which has contracted for several quarters, is also projected to rebound as mortgage insurance rule changes spur demand for housing.

Global Influences and Energy Market Volatility

External factors weigh heavily on the Canadian economic outlook. The global economy is expected to grow at 3%, but uncertainty remains, particularly in China, where weak domestic demand and the ongoing property crisis are holding back growth. The euro area also faces subdued growth prospects. Oil prices remain volatile, impacted by supply concerns and the conflict in the Middle East, affecting Canadian energy export revenues.

The Bank of Canada has acknowledged the role of global developments, especially changes in the U.S. economy, in shaping Canadian economic performance. Stronger U.S. growth can bolster Canadian exports, but weaker global demand and trade tensions may present risks. Notably, lower oil prices have contributed to reduced inflation in Canada, but volatility remains a risk, potentially affecting government revenues and investment in the energy sector.

Navigating Uncertainty: Balancing Risks

The Bank of Canada finds itself navigating a complex landscape of inflationary pressures, potential economic softening, and geopolitical uncertainties. With inflation expectations nearing normal levels, the Bank has the difficult task of balancing further rate cuts with economic stability. Geopolitical shifts, rising trade tensions, and the risk of inflation persistence—especially in services—pose upside risks to the inflation outlook. On the downside, weaker household spending and slowing global growth could weigh further on Canadian economic activity.

The outlook for 2025 is marked by both hope and caution. While rate cuts are aimed at ensuring growth, the Bank must be prepared for a less predictable economic trajectory influenced by both domestic and international variables. How well policymakers balance the interests of fostering growth, managing inflation, and responding to global dynamics will shape Canada’s economic landscape in the years to come.

Conclusion

The Canadian economy's journey through 2025 will be one of balancing opportunities against significant challenges. The Bank of Canada’s policy actions reflect both caution and adaptability as they seek to foster growth while managing inflation and external risks. With an evolving global environment, policymakers must remain vigilant, leveraging rate cuts judiciously to encourage economic resilience. The trajectory of the Canadian economy will ultimately depend on how effectively these policies translate into tangible growth, and how well they mitigate the challenges presented by both domestic and global forces. As Canada faces an uneven recovery, the strength of its monetary policy and the agility of its institutions will be crucial determinants of future prosperity.