Key Takeaways
- The Bank of Canada may need to hike rates if energy prices start pushing up overall inflation, according to analysts.
- A rate cut is a possibility if the oil shock subsides and the economy remains weak.
- A rate hold remains the most likely scenario as the Bank monitors economic data.
Markets have ramped up bets on a July interest rate hike following last week’s Bank of Canada meeting as Iran-war-driven energy prices rise again. But analysts remain divided, with most saying a rate hike is unlikely, while some still expect a cut.
Last week, the Bank highlighted the risk of high oil prices spilling over into broader inflation. This immediately prompted money markets to sharply raise expectations for rate tightening. A rate hike is seen as possible as early as July, with roughly three increases priced in by year-end. However, most analysts say the central bank is more likely to hold rates steady, given the economy’s underlying weakness.
“Without a doubt, current market pricing that implies rate hikes being fully priced in reflects money markets are getting ahead of themselves,” says Joe Brusuelas, chief economist at RSM. “The level of uncertainty on the direction of inflation, growth, and employment due to the ongoing war in the Middle East is simply too high to put much faith in the direction of rates as indicated by current market pricing.”
After a third consecutive pause, which leaves the policy rate at 2.25%, where it has been since December, the Bank described the current situation as a “dilemma.” It’s caught between the opposing forces of weak economic growth (which would ordinarily signal a rate cut) and rising energy inflation (which would warrant a rise).
A Rate Hike Would be a Mistake
BMO chief economist Douglas Porter says factors such as weak job growth, a struggling housing market, tightening financial conditions, and trade uncertainty could force policymakers to stay on hold. “I continue to believe that [a rate hike] would be an extraordinarily bad policy decision,” he says. “Call us old-fashioned, but where’s the case for rate hikes when core inflation is below target?” If the most interest-sensitive areas of the economy, consumer spending and housing market, are struggling, “then it’s patently obvious that policy is not overly easy,” he says.
JP Morgan Asset Management global market strategist Jack Manley completely rules out a hike this year: “One hike would be a fumble; three hikes would be a critical policy error.” He argues that higher energy prices are driving the hike narrative, but that prices “should be somewhat contained, given Canada’s geographic isolation and energy independence, and supply-side issues cannot be solved through monetary policy.”
Avery Shenfeld, senior economist at CIBC Economics, says that for the Bank to hike rates, it would have to be convinced that the oil price shock will endure. “July would be too soon to reach that judgment unless oil-producing assets in the Middle East suffer major damage in the war,” he says. In any case, it would “take time” for energy inflation to seep into other areas, “given the cushioning provided by current economic slack.” He adds that a rate hike this year remains highly unlikely.
The Case for Tightening
David Doyle, head of economics at Macquarie Group, points to the oil shock and slowing population growth as reason to forecast higher rates this year. “A rate hike appears increasingly likely, given the oil price spike and associated inflationary pressures,” he says. “Alongside this, around zero population growth in Canada will mean very low (if not negative) labor force growth. This means even with just slight employment growth, there should be downward pressure on unemployment over time.”
Doyle forecasts a total of 75 basis points of rate hikes, including his “baseline scenario, [which] remains for the Bank of Canada to hike by 25 basis points in Q4 2026 and a further 50 basis points in the first half of 2027.”
Josh Nye, senior economist at RBC Global Asset Management, says the market’s expectation for a rate hike is underpinned by the assumption that Canada is a net energy exporter and benefits from higher prices. “Stronger growth and higher inflation both push in the direction of higher interest rates,” he says. “I wouldn’t rule out the Bank of Canada raising rates this year, [even though] that’s not our base case.”
Door Remains Open for a Cut
Despite mounting evidence to the contrary, some analysts are hesitant to dismiss the possibility of rates moving lower.
“Never say never. I wouldn’t totally rule out the possibility of a rate cut later this year,” says BMO’s Porter.
A cut is not off the table if oil prices decline in the next few months and some of the downside risks—labor market weakness, slower economic growth, and trade uncertainty—materialize, explains CIBC’s Shenfeld.
An aggressive oil price spike could be another scenario in which the Bank might cut rates, according to RBC’s Nye. This would be if an oil shock “proves to be so severe that global and domestic growth prospects are significantly diminished, and central banks feel they have leeway to look through the immediate inflationary impact and focus on the hit to growth and eventual downside risks to inflation.”
Taylor Schleich, an economist at National Bank Financial, says, “If recent jobs data and core inflation momentum (pre-Iran war) were to persist and/or the USMCA [United States-Mexico-Canada Agreement] review proved disruptive/damaging, we could see the Bank of Canada cut in the second half the year.”
JP Morgan’s Manley notes that while “a cut is still on the table,” the central bank is “extremely data-dependent” and might “stay on hold and wait for the dust to settle.”
