2025 Canada economic outlook: On the mend

 

Canada’s economic environment remains as complex as it has been for the past couple of years. However, we're now dealing with a different inflation and interest rate environment.

Given that we've seen a substantial decline in inflation in the past year and interest rates are coming down, the broad economic picture suggests a rebound for the Canadian economy after two years of sluggish performance.

Global economies hum along

As we head into 2025, the pleasant surprise is how resilient the global economy has been over the past couple of years. Nearly all of the world’s largest economies have managed to grow. When we add up all these major global economies, we're looking at overall real growth—that is, adjusted for inflation—of slightly above 3%, which is just below the global economy’s long-run average. We expect similar results in 2025.

The global economy has been so resilient because the world's largest economy—the U.S.—has performed much better than expected. The U.S. has grown almost 3% over the past two years, above its long-run average. Most of Wall Street and many economic forecasters have been caught flat-footed by how resilient the U.S. economy has been throughout the period of high interest rates and high inflation that we've dealt with. The most important driver has been how the strength of the U.S. consumer, with pent-up demand and high excess savings driving better-than-average growth.

Looking into 2025, we expect some factors that boosted the U.S. economy to cool off a bit. We don't expect consumer spending to be quite as strong as it’s been over the last couple of years. On the other hand, President-elect Donald Trump has proposed some relatively pro-growth policies, including the possibility of tax cuts. With that in mind, we've lifted our U.S. economic forecast slightly for 2025 to 2.2%—slightly below its performance for the last couple of years but in line with the long-run average.

The one wild card to watch is to what extent and over what time frame President-elect Donald Trump can enact his proposals on trade and tariffs. Compared to his first term, President-elect Trump does appear to be more intent on taking a more protectionist stance, particularly in relation to China. Canada, however, has remained under the radar in terms of any changes to trade policy or tariffs. For now, we’ll wait to see what exactly the Trump administration is able to push through and how the markets will respond.

The return of the Canadian consumer?

The Canadian economy has struggled to grow by 1% per year over the past two years—well below average, though it doesn’t qualify as a recession. The big difference between Canada and the U.S. boils down to the consumer. Canada is one of the most interest rate-sensitive economies in the world because of our relatively high levels of household debt and how quickly that debt turns over.

The good news is that with interest rates coming down quite dramatically, a significant weight will be lifted off Canadian consumers, which should result in the Canadian economy growing closer to its long-run average of slightly below 2% in 2025.

Changes to Canada’s immigration policy will also have an impact. Real income per person has sharply trailed the U.S. over the past 10 years, in part due to the strong population growth we've seen—about 3% in each of the past two years, one of the fastest growth rates we've seen in several decades. But we're going to see a period of near-zero population growth if the Canadian government sticks to its new immigration targets.

One reason the federal government has changed its policy so abruptly is because strong population growth has put upward pressure on the unemployment rate. Canadian employment growth matched the U.S. in 2024, but stronger population and labor force growth helped to drive the unemployment rate to about 6.5%, compared to slightly above 4% in the U.S.

Looking ahead, with much slower population growth and a pickup in the economic growth rate over the next year, we expect this steep deterioration in the job market to give way to better conditions by late 2025.

Inflation, interest rate outlook

Canada has had better inflation performance than much of the rest of the world. Historically speaking, where the U.S. goes in terms of growth and inflation, Canada tends to follow. But in recent years, Canada's inflation rate has been consistently below that of the U.S.

Among the major industrialized economies, Canada sits at the lower end of the spectrum regarding inflation. Some of that is reflective of the fact that Canada has had a softer economic backdrop compared to other countries, keeping upward price pressures to a minimum. BMO is forecasting an inflation average of less than 2% in 2025. If oil prices fall, the inflation rate could dip even lower.

So, what does this mean for interest rates? The Bank of Canada has been one of the most aggressive rate cutters in the world. One reason is because what’s currently driving inflation is shelter costs. Prices related to housing, excluding the home price itself, have risen significantly, including property taxes, mortgage payments, insurance rates, and rent.

On the other hand, prices are down for automobiles, appliances, and furniture—all of which rose during the pandemic-related supply chain disruptions. If you exclude shelter costs, overall inflation is close to zero, and the Bank of Canada is well aware of that.

That’s why the Bank of Canada has been the most aggressive interest rate cutter in the world. Since June, they've cut rates by 1.25%, and we expect another cut during their final interest rate meeting in December, as well as a series of cuts through mid-2025. All told, we expect the overnight interest rate to fall from the current 3.75% to 2.5% by the middle of 2025. If anything, the Bank of Canada may be even more aggressive.

 

 

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