As the first quarter of 2026 unfolds, Canada finds itself navigating a familiar but evolving set of geopolitical and trade-related headwinds that continue to complicate its domestic economic outlook. While most Canadian exports to the US remain tariff‑exempt under USMCA rules, the persistence of trade policy uncertainty has reinforced a cautious stance among firms, suppressing business confidence and non‑residential investment.

Meanwhile, elevated oil prices stemming from the Iran‑related conflict are likely to provide a modest tailwind for Canada, given its status as a net energy exporter. While higher energy costs may push core inflation higher and weigh on household discretionary spending, the overall terms‑of‑trade effect should remain supportive for the Canadian economy. The Bank of Canada (BoC) could be forced to tighten policy if inflation reaccelerates or if geopolitical developments, including the conflict in the Middle East, begin to lift inflation expectations. With yields having moved higher in Canada, some tightening related to the Middle East crisis has already occurred, even as Canadian labour markets continue to soften.

We conducted scenario analysis to assess the macroeconomic implications of higher oil prices, varying assumptions around both the duration of the Middle East conflict and the resulting impact on GDP, headline inflation, and core inflation. Across all three scenarios, Canada avoids a recession. Our analysis also reveals that a sustained oil price of $150 per barrel throughout 2026 would be sufficient to push the U.S. economy into recession.

The table below summarizes the expected economic effects of elevated oil prices. Our assessment is informed by historical experience and explicitly accounts for offsetting forces from fiscal and monetary policy. For Canada, the key insight is that while higher oil prices lift GDP in all three scenarios, the net growth benefit peaks under the moderate scenario. Prolonged periods of high oil prices disproportionately benefit energy‑producing regions but weigh on aggregate demand elsewhere in the economy, ultimately limiting overall growth.

Figure 1: Anticipated economic effects of higher oil prices

_{Notes: Bps stands for basis points. A basis point is one-hundredth of a percentage point. 
Sources: Vanguard calculations, based on Oxford Economics and Federal Reserve data, as of March 9, 2026.} 

Fiscal policy will add a modest tailwind through targeted sectoral initiatives and ongoing infrastructure programs. Paired with expectations for above‑trend global growth, we forecast Canadian real GDP to expand by 1.8% in 2026. Core inflation eased through late 2025, giving the Bank of Canada room to cut rates by a cumulative 100 basis points last year. We expect the policy rate to stay at the lower end of the neutral rate at 2.25% throughout the year despite the markets pricing in rate hikes for the back half of 2026 as shown in Figure 2, partly driven by concerns that the oil-related inflation might force the BoC’s hand. We expect the BoC to look through supply-driven price shocks as long as inflation expectations remain anchored.

Canada’s job losses in January and February 2026 rank among the most severe outside of major recessions. We expect the unemployment rate to edge lower over the coming quarters, driven less by a rebound in hiring and more by declining labour force participation, an early signal of the demographic slowdown likely to shape the labour market in the years ahead. Real wage growth and a relatively modest pace of further job losses should also help stabilize labour market conditions.

Monetary Policy

Figure 2: US and Canadian Policy Rates and expectations

Source: Bloomberg and the Bank of Canada as of March 23, 2026

At its March 18th meeting, the BoC opted to maintain its policy rate at 2.25%, indicating that headline inflation had eased to 1.8% in February and that the Canadian economy was operating in a state of excess supply as evident with a 0.6% GDP contraction in Q4 2025 and a labour market that was soft. Monetary policy is already sufficiently restrictive due also to weak credit growth, sluggish housing market activity and many households have to refinance their mortgage at a much higher rate in 2026. With these dynamics in mind, officials see little need to raise rates further. Our view is that the markets are incorrectly pricing in too many hikes as these signs argue against tightening monetary policy.

In discussing the potential for a rate cut, Governor Tiff Macklem emphasized that the BoC remains prepared to look through the immediate inflationary effects stemming from the conflict in the Middle East provided these pressures do not translate into persistent inflation. The war-driven surge in global oil prices has temporarily elevated headline inflation in Canada, as well as in other regions. The BoC has indicated its willingness to tolerate a near-term rise in inflation above its 3% upper target band, so long as the increase is clearly attributable to transitory external shocks and long-term inflation expectations remain well-anchored. Canada’s relatively moderate inflation backdrop affords the BoC greater policy flexibility compared to the United States. In this context, the BoC may be open to further rate cuts. However, such a move would depend on confirmation that the energy shock does not prove more severe or enduring than anticipated, nor lead to second-round effects on wages and inflation expectations.

Our assessment is that the Bank of Canada is unlikely to deliver additional rate cuts until there is greater clarity on both the duration and scope of the Middle East conflict, alongside more persistent and broad‑based weakening in labour market conditions. A further constraint on the policy outlook is the inflationary impact of domestic fiscal policy. Large‑scale infrastructure spending, housing initiatives, clean‑economy tax incentives, and increased defence commitments are likely to place a structural floor under how far interest rates can be reduced.

The Bank will also be monitoring developments related to CUSMA, particularly as many investment decisions remain on hold ahead of the joint review, as well as assessing the risk of supply‑chain disruptions stemming from the Middle East conflict. Taken together, these considerations underpin our baseline view that the Bank of Canada will maintain its current policy stance and keep rates on hold throughout 2026.

Inflation

Headline inflation (CPI) has continued to ease and is now below the Bank of Canada’s 2% target, alongside signs of weakness in labour markets. CPI slowed to 1.8% year over year in February 2026 (see Figure 3), down from 2.3% in January, with the deceleration largely reflecting base‑year effects tied to the expiration of the temporary GST/HST tax break, which ran from December 14, 2024 to February 15, 2025. Because the tax relief applied to restaurant meals and beverages and ended partway through February last year, restaurant food prices remained elevated at 7.8% year over year. Even so, overall food inflation moderated to 5.4% in February, down from 7.3% in January, pointing to notable declines in meat prices. Despite this easing, food inflation remains well above headline CPI and continues to be sensitive to energy prices, reflecting the sector’s reliance on fuel inputs and fertilizer production. A prolonged conflict in the Middle East could add upward pressure to food inflation, and adverse weather conditions may compound these effects by increasing food and fertilizer costs.

Figure 3: Canada is making progress on inflation, with both headline and core pressures cooling

^{Source: Statistics Canada}

Excluding volatile food and energy components, Canada’s underlying inflation is close to target and continues to ease. The average of CPI‑trim and CPI‑median, the Bank of Canada’s preferred core measures, slowed to 2.3% in February 2026, down from 2.45% in January. Our analysis suggests that a protracted conflict in the Middle East would raise core inflation by roughly 30 basis points (see Figure 1), while headline inflation could increase by about 75 basis points. Notably, the three‑month annualized average of CPI‑trim and CPI‑median has fallen below 1%, pointing to disinflationary momentum and meaningful progress on inflation, which would give the Bank of Canada greater scope to ease policy should labour market conditions deteriorate further. Soft domestic demand, together with well‑anchored inflation expectations, should help keep core inflation contained. As a result, an energy‑driven pickup in inflation is unlikely to trigger a broader or persistent inflationary spiral, provided wage growth and business pricing behaviour do not respond aggressively to what is expected to be a temporary rise in energy costs.

Beyond the risk of a prolonged conflict in the Middle East, renewed global supply‑chain disruptions and rising labour costs represent upside risks to inflation. Mortgage interest costs have already increased as a result of past interest‑rate hikes. Should the Bank of Canada tighten policy further, higher borrowing costs could push up mortgage interest costs and therefore headline inflation higher. During the 2022–23 hiking cycle, mortgage interest cost inflation at times contributed close to one percentage point to headline CPI, despite its relatively modest weight in the index.¹

We expect year-end core inflation to be approximately 2.2% unless the conflict in the Middle East lasts longer than three months or other external shocks emerge.

GDP Growth

Canada’s real GDP expanded by 1.7% in 2025, driven primarily by domestic demand, with trade headwinds and weak productivity partially offsetting growth. According to the Bank of Canada’s January 2026 projections, household consumption, government spending, housing activity, and modest business investment together contributed roughly 1.7 percentage points to growth, while net exports provided little support. Household consumption proved resilient as declining inflation boosted real wage growth, reinforced by a positive wealth effect stemming from the strong absolute performance of the markets, particularly Canadian equities. Government spending also made a meaningful contribution, supported by infrastructure programs and targeted public investment, even as private‑sector investment remained subdued. Lower interest rates further supported consumer spending and helped stabilize interest‑sensitive sectors.

Net exports, however, were a drag on growth. While Canada’s status as a net energy exporter provided some offset, headline GDP was mechanically supported by declining imports, an adjustment that reflects weaker domestic demand rather than improved competitiveness. Export performance was constrained by sector‑specific tariffs on lumber, steel, aluminum, and non‑CUSMA‑compliant auto parts. Although Canada made some progress diversifying its export exposure away from the United States as illustrated in Figure 4, with the U.S. share of exports declining from 76% in December 2024 to 68% in January 2026, the broader picture remains challenging. Total exports fell by approximately 10% over the same period, underscoring the difficulty of translating diversification efforts into aggregate export growth. 

Figure 4: Canada is diversifying away from the U.S. but overall export volumes are declining

^{Source: Statistics Canada}

Against the backdrop of the current Middle East conflict, Figure 1 suggests that the impact on Canada’s GDP is modest, albeit slightly positive. Prolonged periods of elevated oil prices tend to disproportionately benefit energy‑producing regions such as Canada, but these gains are increasingly offset by weaker aggregate demand elsewhere in the economy. GDP is expected to peak under a moderate scenario in which the conflict persists for three to six months. Beyond that horizon, sustained high oil prices, while supportive of the energy sector, begin to weigh more heavily on consumption and non‑energy activity.

Structural changes in Canada’s energy sector further constrain the upside. Oil and gas investment is now less than half its level a decade ago, and major new energy projects require not only high prices but sustained price certainty over long periods. As a result, the GDP impact of higher oil prices is likely to materialize primarily through higher corporate profits and government royalties rather than a meaningful pickup in capital investment.

Canada’s Q4 GDP contracted by 0.6%, driven largely by inventory drawdowns as firms sold down existing stock rather than expanding production. The more encouraging signal came from final domestic demand, which rebounded as consumer spending, accounting for more than half of GDP, proved resilient. Canadians continued to spend on travel, recreation, and other in‑person services, helping to offset weakness elsewhere in the economy.

Canada’s GDP per capita has been rising in recent quarters, as illustrated in Figure 5. A key driver has been a marked slowdown in population growth, which appears to have turned negative on a net, semi‑annual basis in the second half of 2025 by roughly 75,000 removing a significant drag on per‑person output. Earlier in the cycle, rapid population gains consistently outpaced job creation and output growth, depressing GDP per capita even as headline GDP expanded. By mid‑2025, population growth had effectively flattened, easing the arithmetic dilution of output and allowing GDP per capita to recover.

Figure 5: GDP per capita is rising in Canada, driven less by growth and more by a slowdown in population

Source: Statistics Canada

Fiscal support is also beginning to play a larger role. Public‑sector hiring and infrastructure spending, including projects tied to defence and green initiatives, are injecting incremental demand at a time when private‑sector investment remains soft. Combined with expectations for above‑trend global growth, we forecast Canadian real GDP to expand by 1.8% in 2026. That outlook, however, remains sensitive to external risks, most notably the outcome of upcoming CUSMA negotiations.

Labour Markets

Early 2026 delivered an unexpected shock to the labour market, with Canada shedding nearly 110,000 jobs, even as population growth had already flatlined in the second half of 2025. The two‑month decline was broad‑based and concentrated in private‑sector and full‑time employment, an unhealthy composition for labour market dynamics. Average hours worked also fell sharply, to 31.1 in February from 32.9 in January. While the Labour Force Survey is inherently volatile and monthly readings should be interpreted with caution, the underlying trends are concerning. Consecutive job losses effectively erased most of the employment gains recorded in late 2025, with the bulk of the decline occurring in the private sector, reflecting cutbacks by firms facing weaker demand and rising cost pressures. In February, the unemployment rate rose to 6.7% from 6.5% (see Figure 6).

Figure 6: Youth unemployment continued rising as overall unemployment edged higher in February 2026

^{Source: Statistics Canada}

We expect a demographic slowdown to shape the outlook over the next few years as population growth moderates. Rising full‑time employment, real wage growth, limited job losses, and positive wealth effects from financial markets should provide a solid floor under household consumption, helping to offset softness in business investment.

Over the past year, the manufacturing sector has been hit hardest, reflecting the toll of trade turmoil and weaker foreign demand. Significant job losses have also been recorded in business support services, agriculture, and retail trade. In contrast, health care and social assistance stands out as a key source of employment growth, as hospitals and long‑term care facilities have ramped up hiring to meet rising demand, making it by far the largest contributor to overall job gains.

Despite signs of softening in the labour market, wage growth has remained resilient. As of early 2026, average hourly wages were rising at a pace modestly above inflation, allowing real wages to turn positive again for the first time since 2020.

A defining feature of Canada’s current labour market is the abrupt slowdown in labour force growth. After several years of rapid population expansion, growth has stalled following a deliberate pullback in immigration and non‑permanent residents. Federal policy changes aimed at reducing the number of international students and temporary workers are now clearly visible in the data, as shown in Figure 7, with study permit holders declining across multiple recent quarters. As a result, Canada’s population could contract modestly in 2026, placing downward pressure on labour force participation and shrinking the available pool of workers. While this dynamic may help keep the unemployment rate lower by reducing the number of job seekers, it also constrains labour supply and lowers Canada’s potential GDP over time.

Figure 7: Non‑permanent residents have declined for several quarters, led by fewer international students

Source: Statistics Canada

Looking ahead, we expect labour market conditions to gradually improve as uncertainty recedes, slower immigration tempers population growth, and steady consumer demand supports solid real wage gains. The Middle East conflict is likely to have a disparate regional impact, with energy producing regions benefiting from elevated oil prices, while higher inflation pressures could restrain hiring in more interest and cost sensitive sectors if the conflict is prolonged. We expect the unemployment rate to decline toward approximately 6.5% by year end, supported by accommodative policy settings, slowing population growth and a resilient household sector.

¹ Bloomberg