Bank of Canada Faces Policy Dilemma Amid U.S. Trade War Escalation

The Bank of Canada's job has been complicated by the prospect of weaker growth and higher inflation, thanks to the retaliatory tariff blitz that followed the collapse of trade talks with the U.S.

The impact is also expected to guide the BoC, which will publish its latest decision on Canadian interest rates at 9:45 a.m. ET on Wednesday.

U.S. President Donald Trump's new trade war against the U.S.' second-biggest trading partner includes 50% tariffs on a wide range of Canadian goods. Canada has announced retaliatory tariffs, due to take effect on Sept. 8 and impacting more than $20 billion in goods.

"We expect the BoC to keep a cautious tone, reiterating that uncertainty is high and that it will 'continue to assess the strength of the Canadian economy and the outlook for inflation, and is prepared to adjust monetary policy as needed'," Bank of America economist Carlos Capistran wrote in a Tuesday note, citing previous BoC guidance.

"Trade uncertainty has risen as the trade war with the US has just escalated, which will likely weigh on growth, and core inflation is at the 2% target. We expect only a direct impact from tariffs on inflation, without second-round effects."

The BoC left its benchmark interest rate unchanged at 2.25% for a sixth consecutive decision in July, down from a recent peak of 5%. The Canadian economy grew by 0.8% in the second quarter, strengthening from 0.1% in the first three months of the year.

Meanwhile, the most recent figures show headline consumer inflation accelerated to 3% year-on-year in July, up from 2.8% in June, prompting traders to price three BoC rate hikes over the coming 12 months. But BoA expects the BoC to keep rates on hold over the coming months.

"A firmer 2Q and above-target headline inflation argue for caution, but the escalation of the trade war with the US is the more consequential development for monetary policy, in our view," said Capistran.

Goldman Sachs forecasts a 0.3 percentage point headwind to GDP growth and 0.3 percentage point boost to inflation in Canada as a result of Trump's tariffs.

"These downside growth concerns and continued volatility in trade tensions will likely keep the BoC on hold for the foreseeable future," the bank wrote in an Aug. 28 note.