After months of frozen progress in U.S.-Canada trade negotiations, recent developments suggest a tentative thaw. On June 29, Canada removed its Digital Services Tax on U.S. firms, followed by the elimination of retaliatory tariffs on September 1, gestures aimed at easing tensions and reopening the door to broader talks. These moves were underpinned by the recognition that the effective tariff rate faced by Canadian exporters remains modest at roughly 6%, the lowest among major U.S. trading partners. Importantly, more than 85% of bilateral trade continues to flow tariff-free under the United States-Mexico-Canada Agreement.

The sharp decline in Canadian exports that contributed to a 1.6% annualized contraction in second-quarter GDP likely reflects a temporary pullback following first-quarter tariff front-running and is expected to reverse in the coming months. Meanwhile, Prime Minister Mark Carney has announced a series of large-scale nation-building projects under the new Major Projects Office, aimed at accelerating economic growth, strengthening energy security, and modernizing infrastructure. We expect these initiatives will have a more meaningful impact on GDP in 2026 and beyond. For 2025, we maintain our GDP growth forecast at 1.25%, though the near-term outlook remains highly sensitive to the trajectory of Canada-U.S. trade negotiations.

Canada’s unemployment rate climbed to 7.1% in August, the highest level in nine years outside of the pandemic, after the economy shed 65,500 jobs. Looking ahead, we expect a gradual cooling in the labor market through the second half of 2025, with the unemployment rate likely reaching 7.5% by year-end as economic momentum slows.

The Bank of Canada’s preferred core measures, CPI-median and CPI-trim, remained largely unchanged in August, averaging 3.05% (vs. 3.1% in July). However, the three-month moving average of seasonally adjusted core fell sharply by 100 bps to 2.4%, signaling underlying disinflation momentum. We expect core inflation to end the year at 2.5%.

The policy rate was reduced to 2.5% following three consecutive pauses. This decision was supported by several disinflationary developments, including the removal of retaliatory tariffs on U.S. goods compliant with the Canada-U.S.-Mexico Agreement (CUSMA) and a cooling in core inflation, with the 3-month annualized rate easing to 2.4%. We expect one more cut by the end of 2025.

Monetary Policy

 
The Bank of Canada has lowered its policy rate to 2.5%, citing easing inflationary pressures, a softening labour market, and the removal of retaliatory tariffs. Despite this monetary easing, the Canadian economy remains highly fragmented. While the impact of U.S. trade policy has been less severe than anticipated overall, certain sectors such as automotive, steel and aluminum, and softwood lumber have faced sharper declines due to rising production costs, logistical bottlenecks, and reduced export competitiveness.

This fragmentation is also evident across regions. For example, trade-exposed Windsor, Ontario, reports an unemployment rate of 11.1%, in stark contrast to Kelowna, BC at just 4.1%. The disparity extends to households as well: the income gap between the top 40% and bottom 40% has reached a record 49.0%1. Higher-income households have benefited from strong gains in wages (+4.7%) and investment income (+7.4%), while lower-income groups saw wage declines (-0.7%) and a steep drop in investment income (-35.3%), despite increased government transfers.

Monetary policy is a blunt instrument as it influences demand across the entire economy rather than targeting specific sectors. Given the fragmentation described above, we believe monetary policy is ill-suited to support the workers and businesses most affected by trade tensions. That responsibility falls to fiscal policy. With the launch of the Major Projects Office and its commitment to large-scale nation-building initiatives, fiscal spending has effectively placed a lower bound on how accommodative monetary policy can be. We estimate that this floor is 2%.

 
Monetary policy can also be impacted by the exchange rates particularly because the latter can have an impact on inflation. The recent depreciation of the Canadian dollar against the U.S. dollar, reaching a four-month low on September 27, raises important considerations for the Bank of Canada. A weaker loonie increases the cost of U.S. imports, potentially adding upward pressure to domestic inflation.

Figure 1 illustrates the relationship between the CAD/USD exchange rate (purple dotted line) and the policy rate spread between the Federal Reserve and the Bank of Canada (green dotted line). With the Fed’s current policy rate sitting above our estimated neutral level of 3.5%, and the BoC’s rate below the midpoint of its neutral range at 2.5%, the interest rate differential continues to favor the U.S. dollar. This divergence, should it persist or grow, suggests that the Canadian dollar may face further downside risk unless the BoC signals a more hawkish stance, the Fed cuts more than we expect them to, or external factors shift in Canada’s favor.

Figure 1: Canada vs. U.S. policy rate differentials vs. USD/CAD exhange rate

_{Source: Bank of Canada, Federal Reserve Bank of St. Louis, Bloomberg}

Looking ahead, we anticipate another 25-basis-point cut at either the October or December meeting, contingent on further softening in economic data.

Inflation

Headline CPI rose to 1.9% in August, partly reflecting the fading impact of the carbon tax removal, which had lowered inflation earlier in the year. The Bank of Canada’s preferred core measures, CPI-median and CPI-trim, remained largely unchanged in August, averaging 3.05% (vs. 3.1% in July). However, the three-month moving average of seasonally adjusted core fell sharply by 100 bps to 2.4%, signaling underlying disinflation momentum.

As illustrated in Figure 2, CPIX-XFET which excludes the impact of food, energy, and changes in indirect taxes has recently tracked between the core and headline inflation measures. Over the past seven years, CPIXFET has proven to be the most reliable leading indicator of headline inflation, offering a clearer signal by filtering out volatile underlying components.

Figure 2: CPI-XFET may provide a better gauge of core inflation than the BoC’s preferred measures

_{Source: Bank of Canada}

Grocery price inflation remains elevated; however, excluding it from the Bank of Canada's preferred core measures yields a more moderate inflation rate of 2.4%. Rents, which rose by 4.5% and account for 7.4% of the CPI basket, are the second-largest contributor to inflation after food purchased from stores. The recent moderation in rent growth is partly attributable to a slowdown in population growth, which has eased competition for apartment and condominium rentals.

Shelter inflation overall has declined steadily throughout the year, falling from 4.4% in January to 2.6% in August, driven in part by a sharp drop in mortgage interest costs over the past 12 months.

Looking ahead, several factors are expected to exert downward pressure on inflation. The removal of CUSMA-related retaliatory tariffs, alongside weakening aggregate demand reflected in rising unemployment, growing economic slack, lower mortgage interest costs, and stalled population growth should help temper price growth. Slowing economic momentum in the U.S. will further contribute to disinflationary pressures.

However, the Government of Canada’s planned fiscal stimulus amounting to $115.1 billion in net new spending over five years could offset some of these disinflationary forces. With targeted investments in housing, defence, infrastructure, and support for industries affected by tariffs, the stimulus may add upward pressure to inflation over the longer term, unless accompanied by meaningful gains in productivity. As shown in Figure 3, we expect GDP growth to remain below trend. For 2025, we maintain our forecast at 1.25%, though the near-term outlook remains highly sensitive to the trajectory of Canada–U.S. trade negotiations.

Additionally, higher tariffs in the U.S. could push prices upward there, potentially prompting Canadian firms to adjust their pricing strategies given the close integration between the two economies.

While uncertainty remains elevated, it has moderated from previous peaks, supporting a continued easing in inflation. Overall, we expect core inflation to trend toward 2.5% by year-end as these dynamics take hold.

GDP Growth

On June 29, Canada withdrew its Digital Services Tax on U.S. firms, followed by the removal of retaliatory tariffs on September 1. These steps reflect a strategic recognition that Canadian exporters face an effective U.S. tariff rate of just 6%, the lowest among major trading partners. 

Meanwhile, Prime Minister Mark Carney has announced a series of large-scale nation-building projects under the new Major Projects Office, aimed at accelerating economic growth, strengthening energy security, and modernizing infrastructure. We expect these initiatives will have a more meaningful impact on GDP in 2026 and beyond. Strain on federal revenues stemming from the removal of the Digital Services Tax, a reduction in the lowest marginal personal income tax rate from 15% to 14%, staggered program budget cuts, and the elimination of the consumer carbon tax will constrain the government’s capacity for public spending. These measures, while aimed at easing fiscal pressure on households and businesses, are likely to limit the scope for expansionary fiscal policy in the near term.

The contraction in second-quarter GDP, which fell at an annualized rate of 1.6%, was largely driven by a sharp 27% drop in exports, the steepest quarterly decline since the pandemic. This pullback likely reflects temporary weakness following tariff front-running in Q1 and is expected to reverse in the coming months. Central bankers had anticipated the slowdown, which was compounded by a 10.1% decline in business investment, particularly in equipment and machinery, amid heightened trade policy uncertainty. Meanwhile, consumer spending remained resilient, supported in part by increased discretionary outlays following the removal of the consumer carbon tax, despite stagnant population growth.

Canada’s GDP rose 0.2% in July, marking a rebound after four consecutive monthly declines. Growth was driven by a recovery in oil and gas extraction following wildfire-related disruptions, alongside gains in non-residential building construction (+0.4%) and engineering construction (+0.2%). However, industries directly impacted by tariffs, particularly iron and steel manufacturing, continued to face headwinds."

Figure 3: Growth expected to remain below trend

_{Source: Vanguard Research}

As shown in Figure 3, we expect GDP growth to remain below trend. For 2025, we maintain our forecast at 1.25%, though the near-term outlook remains highly sensitive to the trajectory of Canada–U.S. trade negotiations.

Slowing population growth, now in its sixth consecutive quarter, combined with strong GDP prints in Q4 2024 and Q1 2025 had temporarily lifted Canada’s GDP per capita, as illustrated in Figure 5. However, that momentum has faded, with GDP contracting by 1.6% in Q2 2025.

Figure 4: Canada’s economy shrank on a per-person basis in Q2 2025 despite slowing population growth

_{Source: Statistics Canada}

Labour Markets

 
Canada’s revised immigration targets are expected to slow population growth by approximately 1.4 million over the next three years, as annual permanent resident admissions decline by roughly 100,000 from 465,000 in 2024 to about 365,000 by 2027. Between January and June 2025, the country admitted 125,903 fewer foreign workers compared to the same period in 2024. The share of non-permanent residents has also declined to 7.3%, down from its peak of 7.6%, contributing to the lowest population growth outside of the pandemic since 1946.

Despite this demographic slowdown, the labour market has not overheated, largely due to the dampening effects of U.S. sectoral tariffs on Canadian goods. Policy uncertainty has led many employers to pause hiring, though widespread layoffs have yet to materialize. The unemployment rate rose to 7.1%, its highest level since May 2016, excluding the pandemic period. Longer job search durations are partly contributing to this rise, with the share of workers unemployed for 27 weeks or more reaching its highest level since 1998, outside of pandemic conditions.

Wage growth, as measured by average hourly earnings, slowed to 3.2% in August, down 10 basis points from July. Canada shed 107,000 jobs across July and August, with losses evenly split between part-time and full-time positions. Labour force participation also declined during those two months, falling from 65.4% to 65.1%, its lowest level since the pandemic signaling a broader cooling in labour market conditions.

Figure 5: Real wage growth is losing steam in comparison to 2024

_{Source: Statistics Canada}

In August, job losses were concentrated in trade-related sectors such as transportation, warehousing, and manufacturing, while professional services and education also saw notable declines. In contrast, July’s losses were primarily in culture and recreation and construction.

Youth unemployment remains elevated at 14.6%, a level typically associated with recessionary conditions. This weakness reflects a mix of factors, including higher minimum wages, heightened uncertainty, an increased supply of low-skilled foreign workers, and, though to a lesser extent, automation reducing demand for entry-level roles.

Figure 6: Unemployment’s up—youth hit hardest. 

_{Source: Statistics Canada}