Canada enters 2026 on stronger footing than many anticipated, setting the stage for a year of resilience and opportunity. After navigating a challenging 2025 marked by tariff uncertainty, weak business investment and a softening labor market, conditions are aligning for a notable rebound. Canadian industries have adjusted to the new tariff landscape and strong growth in the US should provide support for Canadian exporters, where global growth fears in 2025 weighed heavily on business investment. Canada’s retains a structural advantage, one of the lowest effective tariff rates among US trading partners, positioning the country to capture greater trade share as supply chains normalize.  

Figure 1: Relative trade advantage has improved for Canada

_{Notes: Post-Liberation Day Expectation is measured using all announced tariffs as of 5/27/2025. 2024 Tariff rates are measured using trade volumes and import duties from 4Q 2024.}

_{Sources: Vanguard calculations based on data from Oxford Economics and US International Trade Commission. Data as of 12/9/2025.} 

Meanwhile, conditions are improving for the domestic economy. The labor market weakened notably in the first half of 2025 but staged a strong rebound in the second half, supported by slowing labor supply growth and trade policy stabilization. However, part of this recovery reflected an increase in part-time employment and a decline in the labor force participation rate. Meanwhile, GDP figures for 2023 and 2024 were significantly revised upward, driven by stronger consumer spending and business investment. These revisions boosted productivity estimates and presented a more resilient growth outlook. In addition, real GDP grew by 2.6% in the third quarter, though this expansion was largely fueled by lower imports and higher government spending rather than a broad-based recovery. Moreover, Canada stands to gain from the anticipated upswing in U.S. economic growth. Vanguard projects U.S. real GDP to accelerate to approximately 2.25% in 2026, with a substantial 60% probability of reaching 3% growth in the coming years, significantly above most consensus and central bank forecasts. This robust outlook is underpinned by accelerating AI-driven capital investment and supportive fiscal policy measures.

Taken together, these dynamics suggest Canada will outperform consensus expectations. We expect real GDP growth of around 1.6% in 2026, supported by resilient consumption, improving labor conditions, fiscal stimulus, a competitive trade position and a favorable policy mix. Inflation should be contained in the mid-2% range, allowing the Bank of Canada (BoC) to maintain an accommodative stance without jeopardizing price stability. While risks persist, particularly around USMCA developments and oil price volatility, Canada’s structural strengths and pragmatic policy approach point to continued resilience as global conditions stabilize and investment momentum builds.

Monetary Policy

At its December 10th meeting, the BoC opted to maintain its policy rate at 2.25%, positioning it at the lower end of the estimated neutral range. This decision reflected several encouraging economic signals including a declining unemployment rate, robust Q3 GDP growth of 2.6%, further boosted by substantial upward revisions, and elevated core inflation at 2.8%¹. Governor Tiff Macklem emphasized that the current rate is “about the right level to keep inflation close to 2% while helping the economy through this period of structural adjustment.”

Canada’s output gap has narrowed, reflecting both a decline in unemployment and upward revisions to GDP. At the same time, potential output has increased due to sizable annual upgrades in productivity growth. Each year’s rate from 2022 to 2024 was raised by 0.7 percentage points, driven by stronger consumer spending and business investment than previously estimated. While higher potential GDP would typically imply greater economic slack, the offsetting effect of improved productivity means slack has actually diminished. On balance, reduced slack suggests the Bank of Canada should proceed cautiously with rate cuts, as easing too aggressively could risk overheating an economy now operating closer to full capacity. Therefore, the BoC will be cautious about further cutting.

As we have mentioned in our previous outlooks, Canadian fiscal policy initiatives such as large-scale infrastructure spending, housing programs, clean economy tax credits, and defence commitments will set a floor on how low interest rates can fall because they inject significant and sustained demand into the economy. With fiscal stimulus supporting growth and employment, the Bank of Canada will have less need to cut rates aggressively to spur activity.

Recently, expectations for a rate hike in Canada during the latter half of 2026 have increased. However, this scenario is unlikely for several reasons. First, labor market dynamics reveal that the drop in unemployment to 6.5% in November was largely driven by part-time job gains and a decline in labor force participation, rather than broad-based employment strength. Second, trade uncertainty persists, with businesses remaining cautious about capital investment. Most importantly, inflation is expected to moderate as retaliatory tariffs will take time to filter through the economy, falling rents are set to ease shelter inflation, and stalled population growth is likely to temper overall price pressures.

Figure 2 highlights the policy rate gap between the U.S. and Canada, which reached its widest point prior to the Federal Reserve’s 25 bps hike on December 10. We expect this differential to narrow slightly in 2026 as the Bank of Canada holds rates steady at 2.25%, while the Fed has limited room to cut below its estimated neutral level of about 3.5%, given resilient U.S. growth and persistent inflation pressures. Our forecast places the Fed’s policy rate at 3.5% by year-end 2026. This trajectory should provide underlying support for the Canadian dollar.

Figure 2: Canada vs. U.S. policy rate differentials

^{Source: Bloomberg}

Inflation

Headline inflation (CPI) held steady at 2.2% in November, even as food prices surged 4.7% year-over-year, the fastest pace in nearly two years. Severe weather, U.S. tariffs on coffee producers impacting supply chains, and a reduction in cattle herds have been key drivers, with the sharpest effects seen in frozen beef and coffee.

The Bank of Canada’s preferred core measures, CPI-median and CPI-trim, eased by 20 basis points to 2.8%. Meanwhile, the three-month moving average of seasonally adjusted core inflation is trending close to the Bank’s 2% target on an annualized basis, with CPI-trim at 2.4% and CPI-median at 2.2%.

Headline inflation in 2026 is expected to remain volatile, driven by food and energy price fluctuations and tax-related base effects stemming from the GST/HST holiday that ran from December 14, 2024, to February 15, 2025. Oil price swings could further amplify this volatility. Additionally, stricter procurement rules or sector-specific concessions during the mid-2026 CUSMA joint review could introduce cost-push pressures through higher import costs and supply chain disruptions

Core inflation is projected to remain anchored in the mid‑2% range, enabling the Bank of Canada to sustain an accommodative policy stance without jeopardizing price stability. We expect core inflation to end 2026 near 2.3%, supported by several disinflationary factors. Slowing population growth should ease housing demand, exerting downward pressure on rents. The phased removal of retaliatory tariffs under CUSMA will gradually alleviate cost pressures on imported goods and manufacturing supply chains, tempering inflation in core goods categories. Additionally, a stronger Canadian dollar has already reduced import prices and is anticipated to remain resilient through 2026, reinforcing the cooling trend. On the labor market front, as shown in Figure 3, the number of Canadians experiencing long-term unemployment has stabilized at an elevated level since mid‑2023, adding slack to the economy and contributing to weaker wage growth and subdued consumer spending, further dampening core inflation.

Figure 3:  Number of Canadians Experiencing Long-Term Unemployment

^{Source: Statistics Canada}

Core inflation will also be impacted by fiscal spending tabled in the Canadian budget. It will put mild upward pressure on core inflation, particularly beyond 2026, as stimulus-driven demand interacts with structural constraints. Near-term, inflation remains contained due to offsetting disinflationary forces, but risks tilt toward the upside if productivity improvements lag.

Figure 4 shows inflation measures easing in November, with CPI-median and CPI-trim declining to roughly 2.8% from 3.0% in October, indicating that underlying price pressures are moving closer to the Bank of Canada’s target range. This moderation is expected to persist into 2026.

Figure 4: Underlying Price Pressures Soften as Headline Inflation Stabilizes

^{Source: Statistics Canada}

GDP Growth

Canada’s economy grew at an annualized pace of 2.6% in the third quarter, far surpassing expectations of roughly 0.5%. The upside surprise was driven primarily by robust government spending and a marked improvement in the trade balance. Federal expenditures surged, particularly in defense, with spending on military hardware jumping 82%.

However, the headline number masks underlying weakness. Much of the GDP boost came from a sharp drop in imports, which mechanically inflates growth but signals softer domestic demand. Lower imports often reflect reduced consumption and investment, and can disrupt supply chains, hinder production, and erode competitiveness. Indeed, household consumption fell 0.4%, while final domestic demand slipped 0.1%. Business investment continued to decline, and firms pared back inventories amid heightened uncertainty.

The most encouraging development for Canada’s economy is the substantial upward revision of GDP figures for 2023 and 2024, reflecting stronger consumer spending and business investment. These adjustments have lifted productivity estimates and signaled a more resilient growth outlook. As shown in Figure 5, the revised GDP per capita (adjusted estimate) is considerably higher than earlier projections. This revision points to stronger economic momentum and suggests that perceived slack in the economy is much smaller than previously thought.

Figure 5: Canada’s GDP Gets an Upgrade: Stronger Growth Than Expected

^{Source: Bloomberg}

For 2026, the Bank of Canada’s measured stance, keeping rates near the lower end of neutral, will support credit-sensitive sectors like durable goods and the challenged housing market. Fiscal stimulus announced in the 2025 budget will provide a modest boost while structural reforms, such as reducing interprovincial trade barriers and closing the post GFC US-Canada labor productivity divergence, reinforce Canada’s long-term growth potential.

Canada’s growth outlook will hinge heavily on the outcome of CUSMA negotiations with the U.S. administration. Washington is pressing for expanded access to Canada’s dairy market, the removal of provincial restrictions on U.S. alcohol, and revisions to the Online Streaming Act and Online News Act, which it views as discriminatory toward U.S. digital service providers. Failure to address these demands could result in higher tariffs or the loss of preferential market access, outcomes that would significantly harm Canadian exporters and raise costs for businesses.

Diversifying trade relationships and removing interprovincial barriers remain important goals, but they are long-term projects that will take decades to achieve. This makes a positive outcome in the CUSMA negotiations essential for maintaining Canada’s economic momentum. In the short term, fiscal measures should help cushion the economy, including increased defense spending, expected to reach 5% of GDP by 2035, alongside a middle-class tax cut, elimination of the consumer carbon tax, and government-backed loan guarantees and liquidity support. However, considerable uncertainty persists regarding the execution of government-initiated projects and whether defense spending will deliver spillover benefits to the civilian economy by driving broader innovation and productivity gains.

For 2026, we expect GDP growth to be 1.6% supported by resilient consumption, improving labor conditions, fiscal stimulus, a competitive trade position and a favorable policy mix.

Labour Markets

Canada’s population declined by 76,000 people, marking its first drop outside of the pandemic since 1947 and bringing the total to 41.6 million. The drop was driven almost entirely by a sharp reduction in non-permanent residents (NPRs), which fell by 176,000 in the quarter. This comes on the back of Canada’s revised immigration targets are expected to slow population growth by approximately 1.4 million over the next three years. Businesses are cautioning that labor shortages could weigh on growth, even as the slowdown may bring some relief to housing affordability and ease pressure on an overstretched healthcare system. Slower population growth reduces the need for job creation to maintain the current unemployment rate.

The labor market delivered some good news as the unemployment rate fell sharply from 6.9% to 6.5% in November, marking the largest monthly decline since early 2022. However, for the second consecutive month, most job gains were concentrated in part-time positions, and November saw a 26,000-person drop in labor force participation. It’s worth noting that the Labour Force Survey can be volatile on a month-to-month basis.

Looking at 2025 as a whole, Canada added roughly 325,000 jobs, reflecting a year of uneven but positive growth. The first half of the year was sluggish, with only about 144,000 jobs created by June, but momentum accelerated in the second half. Between September and November alone, 181,000 positions were added, and the final quarter delivered an additional surge of 180,000 jobs.

Job gains were concentrated in health care, social assistance, accommodation, and food services, with additional contributions from manufacturing and natural resources. However, a large portion of late-year growth came from part-time positions, highlighting that while the labor market strengthened, underlying conditions remain uneven. As shown in Figure 3, the number of Canadians experiencing long-term unemployment remains elevated compared to 2023, when it began trending upward, though it has recently stabilized. Trade-related sectors were another area of concern. Despite facing significant pressure, strong commodity exports, fiscal support, and adaptive business strategies helped prevent deeper job losses than might have occurred under prolonged trade disruptions.

Figure 6 shows that unemployment declined for both youth and the overall population in November, narrowing the gap between the two. Despite this improvement, 2025 was one of the most challenging years for young Canadians, with unemployment reaching recessionary levels even as the broader labor market remained resilient. While conditions eased slightly toward year-end, structural challenges including skills mismatches, demographic pressures, and sectoral weaknesses continue to pose significant headwinds.

We anticipate the labor market will gradually strengthen as uncertainty recedes, slower immigration tempers population growth, and steady consumption supports solid real wage gains. By year-end, we expect the unemployment rate to decline to approximately 6.2%.

Figure 6: The gap between youth employment and overall employment has narrowed

^{Source: Statistics Canada}

¹ Average of CPI median and CPI trim, the Bank of Canada’s preferred measures of core inflation