OECD warns Bank of Canada may need to hike rate in tariff war

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Canada’s economy may have ended 2024 on a high note, but that could all be undone as world trade is upended by Donald Trump’s tariff war, according to a new report by the Organization for Economic Co-operation and Development (OECD).

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The OECD cut its growth forecast for Canada by more than half Monday, and predicted knock-on effects on inflation and interest rates that could result in the cost of borrowing rising and staying higher for longer if the country ends up facing 25 per-cent tariffs from the United States and a tit-for-tat retaliation. The analysis also accounts for tariffs exchanged between China and the United States, as well as Washington’s broad-based 25 per cent tariffs on steel and aluminum imports, which include Canada.

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Here’s a look at what the OECD had to say about Canada.

Growth prospects

The OECD now expects Canada’s gross domestic product (GDP) to grow by 0.7 per cent this year and next, down 1.3 percentage points from its previous projection in December.

The policy uncertainty created by tariffs will hit Canadian companies and households alike, forcing them to hold back spending on capital investment and durable goods, the report said.

Canada’s growth forecast was among the lower projections made by the OECD, which cut the outlook for most of its 38 nation members. Mexico, also in Trump’s tariff sights, was the only country where the OECD forecast the economy would contract over the year — shrinking 1.3 per cent.

The U.S. economy, meanwhile, is expected to grow 2.2 per cent this year, down 0.2 percentage points from the previous report, and 1.6 per cent next year, down 0.5 percentage points.

Canada’s growth prospects for this year and next dramatically improve if the U.S. extends tariff exemptions beyond April 2 for goods that are compliant with the Canada-United-States-Mexico Agreement (CUSMA).

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In that case, Canada’s growth is projected at 1.3 per cent in 2025 and 2026, and Mexico would avoid a recession as long as the two countries lower any retaliatory tariffs.

Inflation

If widespread tariffs take hold, Canada’s headline inflation rate is expected to surge 1.1 percentage points in 2025 to 3.1 per cent before cooling somewhat to 2.9 per cent in 2026. January’s inflation rate was 1.9 per cent.

Core inflation is forecast to jump to a rate of 3.1 per cent in Canada in 2025, breaching the top end of the Bank of Canada’s target range. The OECD’s report also warns that one of the many dangers posed by the tariffs is that they will fuel inflation expectations.

Central bank policymakers worry about rising inflation expectations because they can have real-world consequences on the spending decisions of businesses and households, as well as wage demands as workers seek higher pay to offset their expected rising costs of living.

At the end of 2024, inflation expectations appeared to be falling in line with central banks’ goals, but there are now signs they are rising again, at least in the U.S.

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The OECD also warned that rising inflation expectations and slowing growth could “trigger a rapid repricing in financial markets and a further rise in market volatility.”

Interest rates

Widespread trade barriers and high tariffs would increase inflation globally, prompting interest rates to rise as well, the OECD report said.

The Bank of Canada cut its rate last week by 25 basis points to 2.75 per cent, but said it would be keeping a close eye on inflation when making future rate decisions.

In the OECD’s worst-case scenario for tariffs, it forecasts interest rates in Canada will rise by 1 to 1.25 per cent, higher than the 0.25 to 0.5 percentage point average it predicts for other major economies.

It also said interest rates will need to stay higher for longer than previously expected as the cost of tariffs filters through to consumers.

The OECD said policymakers can continue to cut interest rates, but only if they are dealing with a “lighter tariff scenario” as slowing growth counterbalances rising prices for goods.

• Email: gmvsuhanic@postmedia.com

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