Canada – Reducing spare capacity

Canada’s GDP looks set to rise by 1.1% in 2024, in line with our view since April but quicker than forecast a year ago. Inflation has fallen faster with the headline at 2.0% and the core median rate at 2.4% – above target but much closer than we expected a year ago. This allowed the Bank of Canada (BoC) to ease policy faster than expected; it is forecast to end 2024 with a final 0.50% cut in its policy rate to 3.25%, 100 basis points (bp) more than we anticipated last year. The BoC estimates an output gap that reached 1.3% of GDP by mid-2024 as subdued growth fell short of a potential rate it estimates between 2.1- 2.8%. It sees this adding disinflationary pressure. The BoC has been easing policy closer to neutral (estimated 1.75-2.75%) to close the gap and anchor inflation around target (Exhibit 1).

Several factors could help narrow the output gap across 2025. First, we forecast growth to accelerate next year. There is some evidence the fast pace of BoC easing has underpinned a revival in consumer confidence and started to firm retail activity. Indeed, with the fading impact of the mortgage rate increase into 2025, the BoC’s cuts could soften the mortgage conditions headwind, while more subdued inflation would firm real disposable income growth. We remain cautious about business and residential investment outlooks. Yet we now forecast GDP growth accelerating to 2.1% in 2025.

This would not close the output gap alone but the BoC estimated a slowdown in potential growth to 1.1-2.4% in 2025 as temporary migrant workers fall and a more recent restriction to target 1.1m total migration between 2025-2027 should slow it further. Alongside our own weaker productivity estimates, these suggest potential growth towards the lower end of the BoC’s range, indicating less excess supply and tempering cuts.

Inflation has fallen faster than we forecast reflecting globally familiar combinations of improved supply conditions, labor matching, and energy markets. Inflation is on track to average 2.4% in 2024, but we expect this to fall further into next year, to average 1.7%, before rising to 1.9% in 2026.

As such, we expect the BoC’s enthusiasm for policy cuts to fade early next year. We forecast the BoC to slow cuts to a 0.25% clip in early and expect it to stop cutting at the upper end of its neutral rate assessment – at 2.75% in March – as it recognizes improvement in activity following its prompt easing, wary of the lags in monetary policy.

External developments are likely to be key, none more so than the U.S. elections. The new U.S. administration is likely to see a series of measures that further restrict the BoC’s space to ease policy further. U.S. tariffs, which we expect to exclude Canada, would further boost spillovers of persistent solid U.S. GDP growth into 2025. Moreover, a weaker Canadian dollar – currently around 20-year lows – would limit BoC divergence from the Federal Reserve.

Canada also faces its own election. While Prime Minister Justin Trudeau’s minority Liberal government could fall earlier, an election must be held by October 2025. Current polling suggests right-of-center Conservatives, led by Pierre Poilievre, would emerge as the new government. Parties have not published manifestos, but concerns about social spending would make a shift in the tax and spend balance likely, which could add headwinds to the 2026 growth outlook.

We expect growth momentum to soften in 2026, largely on the back of a slowing U.S. economy, and we forecast Canadian GDP growth of 1.7%. An externally led slowdown, with the economy still exhibiting spare capacity, is likely to prompt the BoC to resume easing, and we expect the policy rate to close 2026 at 2.25%.

Source: All data from AXA IM, as of November 2024 unless otherwise indicated