Bank of Canada Can Now Pick Its Fight: Inflation Over Growth
The overnight rate has been sitting at 3.75 percent since December, and when the Bank of Canada meets this week, the consensus is that it will stay there. Not because the central bank has run out of moves, but because it no longer needs to make them.
For eighteen months, the Bank faced a choice between two bad outcomes: raise rates and risk tipping a fragile economy into recession, or cut them and watch inflation expectations drift away from the 2 percent target. That bind has loosened. GDP growth is running at 1.3 percent, anemic, but positive. Inflation is hovering near 2.4 percent, within the target band but stubbornly above the midpoint. The absence of crisis gives the Bank something it hasn't had since 2021: time.
The shift is structural, not seasonal. Canada's unemployment rate has climbed to 6.3 percent from its 2022 low of 4.9 percent, but mass layoffs have not materialized. The vacancy-to-unemployed ratio, which spiked during the pandemic labor shortage, has returned to pre-2020 norms. Wage growth is decelerating. The pressure that made inflation a runaway problem in 2023 has dissipated without the economy collapsing.
Why holding is riskier than it looks
A stable policy rate does not mean a stable outcome. Monetary policy works on lag, and the decisions the Bank made in 2024, when it cut rates three times after holding them at restrictive levels for nearly two years, are only now fully expressing themselves in consumer behavior. Mortgages that were signed at 1.79 percent in 2021 have rolled over into renewals at 5.2 percent. Debt servicing costs as a share of disposable income have climbed to levels last seen in the early 1990s. Canadians have responded by cutting discretionary spending, not by defaulting en masse, which is why the soft landing is holding. But the margin for error is thin.
The Bank's current posture assumes that inflation will continue to drift downward without additional tightening. That assumption rests on two things: stable energy prices and continued productivity gains in the service sector. Neither is guaranteed. Shelter inflation, driven partly by mortgage interest costs but also by structural supply constraints in housing, remains elevated. A premature hold could let inflation expectations resettle at 2.5 percent instead of 2 percent, a drift that would be expensive to reverse.
The productivity problem the Bank cannot solve
The deeper issue is not inflation or growth, but the fact that Canada's economy is no longer capable of producing more output per hour worked. Business investment has stagnated. Capital per worker has been flat since 2015. The green energy transition, which other G7 economies are using as a catalyst for infrastructure spending, has not yet translated into comparable investment in Canada. The Bank of Canada can set the cost of borrowing, but it cannot fix the fact that firms are not borrowing to expand capacity.
This matters because the "neutral rate", the level at which monetary policy neither stimulates nor restricts, may have shifted higher. If productivity is permanently lower, then any given interest rate is less restrictive than it would have been a decade ago. The Bank's current estimate of neutral is around 2.75 percent. If that estimate is wrong, then 3.75 percent is not as tight as it feels, and holding now may be easing by stealth.
The last mile to 2 percent inflation is always the hardest. The Bank of Canada has bought itself the luxury of patience, but patience is not the same as resolution. Growth is weak but not collapsing. Inflation is contained but not conquered. The dilemma has not disappeared. It has just become quieter.
The overnight rate has been sitting at 3.75 percent since December, and when the Bank of Canada meets this week, the consensus is that it will stay there. Not because the central bank has run out of moves, but because it no longer needs to make them.
For eighteen months, the Bank faced a choice between two bad outcomes: raise rates and risk tipping a fragile economy into recession, or cut them and watch inflation expectations drift away from the 2 percent target. That bind has loosened. GDP growth is running at 1.3 percent, anemic, but positive. Inflation is hovering near 2.4 percent, within the target band but stubbornly above the midpoint. The absence of crisis gives the Bank something it hasn't had since 2021: time.
The shift is structural, not seasonal. Canada's unemployment rate has climbed to 6.3 percent from its 2022 low of 4.9 percent, but mass layoffs have not materialized. The vacancy-to-unemployed ratio, which spiked during the pandemic labor shortage, has returned to pre-2020 norms. Wage growth is decelerating. The pressure that made inflation a runaway problem in 2023 has dissipated without the economy collapsing.
Why holding is riskier than it looks
A stable policy rate does not mean a stable outcome. Monetary policy works on lag, and the decisions the Bank made in 2024, when it cut rates three times after holding them at restrictive levels for nearly two years, are only now fully expressing themselves in consumer behavior. Mortgages that were signed at 1.79 percent in 2021 have rolled over into renewals at 5.2 percent. Debt servicing costs as a share of disposable income have climbed to levels last seen in the early 1990s. Canadians have responded by cutting discretionary spending, not by defaulting en masse, which is why the soft landing is holding. But the margin for error is thin.
The Bank's current posture assumes that inflation will continue to drift downward without additional tightening. That assumption rests on two things: stable energy prices and continued productivity gains in the service sector. Neither is guaranteed. Shelter inflation, driven partly by mortgage interest costs but also by structural supply constraints in housing, remains elevated. A premature hold could let inflation expectations resettle at 2.5 percent instead of 2 percent, a drift that would be expensive to reverse.
The productivity problem the Bank cannot solve
The deeper issue is not inflation or growth, but the fact that Canada's economy is no longer capable of producing more output per hour worked. Business investment has stagnated. Capital per worker has been flat since 2015. The green energy transition, which other G7 economies are using as a catalyst for infrastructure spending, has not yet translated into comparable investment in Canada. The Bank of Canada can set the cost of borrowing, but it cannot fix the fact that firms are not borrowing to expand capacity.
This matters because the "neutral rate", the level at which monetary policy neither stimulates nor restricts, may have shifted higher. If productivity is permanently lower, then any given interest rate is less restrictive than it would have been a decade ago. The Bank's current estimate of neutral is around 2.75 percent. If that estimate is wrong, then 3.75 percent is not as tight as it feels, and holding now may be easing by stealth.
The last mile to 2 percent inflation is always the hardest. The Bank of Canada has bought itself the luxury of patience, but patience is not the same as resolution. Growth is weak but not collapsing. Inflation is contained but not conquered. The dilemma has not disappeared. It has just become quieter.
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