Bank of Canada Signals Hawkish Turn, Upside Inflation Risks Ahead

The Bank of Canada recently adopted a more hawkish tone in its policy decision, emphasizing upside inflation risks despite subdued core inflation. TD Securities economists Robert Both and Emma Lawrence attribute this shift to a greater emphasis on inflation upside risks.

According to the economists, the Overnight Rate is expected to remain at 2.25% through 2026 before returning to neutral at 2.75% in 2027 via two 25 bp hikes. This suggests that the Bank of Canada will maintain its accommodative stance for now but may tighten monetary policy next year.

Trade tensions and oil shocks are seen as significant risks, but they do not currently pose a deterrent to rate hikes. Oil prices have normalized after surging above $100bbl in response to the US-Iran conflict, introducing a meaningful shock to inflation expectations with headline CPI near the top of its 1-3% target range.

TD Securities expects the Bank of Canada to remain patient as it waits for more clarity on the geopolitical outlook and spillovers to domestic CPI. The combination of well-anchored expectations, narrower inflation breadth, and muted core inflation momentum is seen as leaving the Bank positioned to look through stronger headline CPI as excess supply is gradually absorbed.