Trump tariff threat looms over interest rate path in 2025

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Most economists a month ago likely would have told you that Canadian interest rates would steadily decline during the first half of 2025 before stabilizing in the third quarter.

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But that was before United States president-elect Donald Trump introduced the threat of a 25 per cent tariff on all Canadian imports, a “major new uncertainty” that even Bank of Canada governor Tiff Macklem said is clouding policymakers’ outlook.

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“They’ll have to be … humble and nimble,” Jimmy Jean, chief economist at Desjardins Group, said, echoing a favourite refrain of U.S. Federal Reserve chair Jerome Powell.

Given the range of projections for 2025, central bank watchers in Canada may want to heed that advice as well.

On the hawkish side, the Bank of Nova Scotia has the Bank of Canada cutting the policy rate by 25 basis points in the first quarter to three per cent, and then holding it there for the rest of the year.

But Royal Bank of Canada has the rate falling to two per cent before the end of next year. Chief economist Francis Donald said the Canadian economy has lost momentum, so rates need to move into stimulative territory and not remain in the Bank of Canada’s neutral range of 2.25 per cent to 3.25 per cent.

“The job market continues to weaken, the unemployment rate will rise, most levels of activity from businesses to households are soft and momentum is weak,” she said. “Our call for two per cent is both a call on where we think we have to drive through neutral, and it’s also a call on the fact that we think this economy needs more support.”

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Toronto-Dominion Bank (TD) lands in the middle, predicting the overnight rate will fall to 2.25 per cent by the end of 2025.

“I’ve been calling this the ‘entering the probing phase’ to figure out how low rates need to go,” said James Orlando, a senior economist at TD, who sees 100 basis points in cuts coming over the course of the year.

These outlooks could go out the window if Trump follows through on his threat to impose a 25 per cent tariff on all goods from Canada when he takes office.

“Ultimately, if we did get hit by that sort of shock, we’re going to have to respond by getting more out of the domestic side of the economy,” Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, said in a year-end webinar. “So, we will likely have to take rates even lower than we expect.”

Jean believes the worst-case tariff scenario would mean cutting the policy rate by an extra 75 basis points from Desjardins’ base case, which assumes there will be tariffs but to a lesser extent.

“In this case, yes, indeed, we have the Bank of Canada reducing interest rates faster,” he said. “Landing interest rates at 1.5 per cent, given that this has the Canadian economy in a recession in our view.”

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Orlando thinks the 25 per cent tariffs would prompt a tit-for-tat response from Canada and, like Jean, believes the policy rate would have to fall to 1.5 per cent.

“We get economic growth in negative territory, so there’s the risk of recession, and in that environment, even though inflation would be higher, the economic risk would justify the Bank of Canada cutting even faster,” he said.

But even if Trump decides not to follow through on implementing such a steep tariff, the very threat of such a measure could be a drag on business investment in Canada.

“Even the threat of that tariff could stall capital spending on this side of the border,” Shenfeld said.

Apart from trade uncertainty, another factor that poses a downside risk to the economy next year is the potential for negative population growth because of the new lower immigration targets set by the federal government for the next two years. It expects the population to decline by 445,901 people in 2025 and by 445,662 in 2026.

An estimate by Statistics Canada has the Canadian population declining by 0.2 per cent in both 2025 and 2026, and the Bank of Canada has said it will be revising its gross domestic product forecast downward for the year as a result.

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However, economists believe the new targets will not have as much of an impact on growth and will be outweighed by a rebound in consumer spending.

“The fact that you have population slowing, whether or not that even happens in actuality is debatable,” Orlando said. “But what’s going to offset it even more is that the Canadian consumer is back spending.”

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