We expect continued easing with a 2025 year-end policy rate near the low end of the BoC’s neutral rate estimate range of 2.25% to 3.25%. We expect GDP to remain below trend in part due to Canada’s stalled population growth following the recent reduction of immigration targets, although a boost from household consumption due to relief from higher interest rates should provide a counterbalance in the second half of 2025. At the end of 2025, we feel unemployment will rise to 6.8% and core CPI (median) will fall from its current level of 2.6% to 2.2%.

Monetary Policy

The Bank of Canada has cut policy rates four times this year, bringing its key overnight interest rate down to 3.75%. An interest rate cut by the US Federal Reserve coupled with a weaker-than-expected jobs report increased the odds of easing. However, the weakening Canadian dollar, new government stimulus cheques sent to millions of Canadians, and potential for igniting upward pressure on the housing market will be a cause for concern for the BoC.

Households and businesses felt the impact of higher interest rates as the household disposable income allocated to interest payments on loans and mortgages has reached the highest levels since the 1990s (chart 1). 

Chart 1: Interest paid as a percentage of disposable income compared with the BoC policy rate

^{Source: Refinitiv, Vanguard calculations}

Easing monetary policy is a welcome sign for consumers and households. More than four million mortgages are expected to be renewed in the next two years, and most of those homeowners locked in at low rates in 2021 and 2022. Given that Canadians usually hold mortgages with terms 5 years or lower, households are more sensitive to interest rate changes. Historically, there has been a strong relationship between policy rates and interest payments on loans as a percentage of disposable income. However, there is a time lag for changes in interest rates to trickle down to the real economy. We expect that households should start feeling the relief from higher interest rates sometime in the second half of 2025. 

We continue to expect that the BoC will continue easing monetary policy through 2025, but rates are expected to settle at a higher level relative to the post Global Financial Crisis period. We expect the terminal rate to settle at 2.25-2.5%, near the lower end of the estimated neutral rate range. 

Inflation

Inflation has come down significantly from its peak in June 2022. Shelter inflation remains a big contributor to inflation as mortgage interest costs, rents and property taxes were amongst the top five contributors to annual inflation. Inflation was only 0.9% excluding shelter in October.

In the chart below, we can observe the impact that mortgage interest costs have on inflation and its positive, albeit lagging, correlation with policy rate. As we can see in chart 2, the BoC hiked rates in April 2022. Gradually, mortgage interest cost’s contribution to inflation rose and peaked at over 40% as recently as September 2024. As continued policy easing makes its way through the system, we expect lower mortgage interest to contribute to a decline in the BoC’s preferred core inflation measures. Canada is one of the few countries that includes mortgage interest cost as a component of core CPI. Were it not included in Canada’s CPI in October 2024; inflation would have been closer to 1.4% than the reported 2.0%¹.

Chart 2: Policy easing will lower mortgage interest costs and thus bring down inflation

^{Source: Bloomberg}

US president-elect Donald Trump’s expected policy of higher tariffs, increased fiscal stimulus and change in immigration policy will have an impact on Canada. Inflation could also rise in Canada as it braces for higher tariffs and lower GDP growth. Upcoming renegotiations of the US-Mexico-Canada (USMCA) trade pact will be critical as the focus will also be on using Mexico as a backdoor to evade US tariffs on Chinese goods.

Trade between the US, Mexico and Canada is critical for all parties. In 2023, total exports between Canada, U.S., and Mexico were $1.5 trillion. Roughly 75% of Canadian exports are destined for the U.S., and 30 US states have Canada as their top trading partner. Canada has a goods trade surplus with the U.S. at over 7% of GDP, largely driven by energy exports. A blanket 10% tariff on Canada by the US would increase input costs for both countries. Canada had a trade surplus of over 128 billion with the US in 2023² and almost 2 million Canadian jobs³ are directly or indirectly impacted by trade with the US.

Chart 3 below highlight how important the trade relationship with the US is for Canada and that trade policy between the two countries may pose a downside risk to Canada’s GDP growth.

Chart 3:  The US is by far Canada’s largest trading partner 

^{Source: Bloomberg}

Chart 4: Top exports from Canada to the US

^{Source: United Nations COMTRADE, 2023 data}

Higher tariffs will also impact the Canadian dollar. The Canadian dollar has slipped to its lowest level in 5 years, declining from a peak of 83 cents US on May 29, 2021, to a rate of 71 cents on November 28, 2024. Lower productivity in Canada coupled with lower relative growth have contributed to its sharp decline. This has resulted in higher import costs which have stressed Canadian businesses, particularly those that are reliant on US inputs, which is inflationary. However, Canadian exporters, and in particular manufacturers, could benefit in the form of increased manufacturing sales and higher employment to produce those goods. Canadian tourism, auto parts, oil, steel, and lumber exports may also benefit, although US imposed tariffs could negate or eliminate the benefit to exporters.

Monetary policy divergence has also led to a weaker Canadian dollar as the Canadian central bank eased policy earlier and more aggressively than the US federal reserve. We expect the gap between US and Canadian policy rates to widen more as we are expecting the US and Canadian policy rates to end 2025 at and 4.0% and 2.5%, respectively. A 150-bps differential could put pressure on the loonie. 

US president-elect Donald Trump’s pro-growth agenda that could focus on slashing taxes, deregulation, and increased tariffs has boosted the US dollar’s relative attractiveness. Stronger GDP growth in Canada, especially if driven by consumer spending, could benefit the Canadian dollar. That is not our base case as we expect GDP growth in 2025 to be at 1.7%, below its trend growth of 2.1%. The wealth effect could be a catalyst for higher consumer spending, particularly if housing prices rise.

Chart 5: CAD/USD Rate is close to its 5-year low

^{Source: Bloomberg}

GDP Growth

With interest payments set to be lower, the allocation of consumer spending to financing charges should decrease, leaving more cashflow for household savings and spending. The increased allocation to spending should boost Canada’s growth. However, an offset could come from stalled population growth via the recent reduction of immigration targets.  Therefore, despite supportive monetary policy we expect Canada’s growth to remain below trend next year.

The federal government plans to send cheques to millions of Canadians this spring that could improve the growth outlook as it offers a significant boost to income and consumer spending early in 2025. This could result in a temporary rise in inflation.  They also announced a two-month GST holiday that will begin in mid-December and be applicable to restaurant meals, shoes, children’s clothes, Christmas trees diapers, books, puzzles, games and toys, snacks, beer and wine, and prepared foods.

Accounting for Canada’s rising population, its real GDP per capita has been deteriorating for many years (chart 6), negatively impacted by low productivity, particularly in R&D, and a rising population. Chart 6 shows how GDP per capita has declined as Canada’s population has grown.

Chart 6: GDP per capita has declined as Canada’s population has grown

^{Source: Statistics Canada}

Labour Markets

The Canadian federal government updated its three-year targets regarding permanent residents. It will now welcome 390,000 new permanent residents in 2025, down from 500,000 in 2024. Canada also aims to reduce targets for temporary foreign workers. They currently comprise 7% of the population which the government hopes to bring down to 5%. These changes, although difficult to implement, will tighten the labour force with the potential to put upward pressure on wages. 

Immigrants and the youth population have contributed significantly to the recent rise in Canada’s unemployment. The economy has found it challenging to absorb workers and the population has growth rapidly and there has not been a surge in layoffs. As chart 7 shows, the rate of unemployment of new immigrants and youth have driven up the unemployment rate recently although both groups faced some relief in September and October.

Chart 7: Youth and new immigrant unemployment rates have recently contributed more to Canada's unemployment rate

^{Source: Statistics Canada}

We expect the unemployment rate will gradually trend upward and end 2025 around 6.8%.

^{1, 2} Source : Bloomberg

³ Source: Statistics Canada.