Canada 2026: poised to outperform

Conditions are aligning for a notable rebound

Canada enters 2026 on stronger footing than many anticipated, setting the stage for a year of resilience and opportunity. After navigating a challenging 2025 marked by tariff uncertainty, weak business investment, and a softening labor market, conditions are aligning for a notable rebound.

Canadian industries have adjusted to the new tariff landscape and strong growth in the U.S. should provide support for Canadian exporters, where global growth fears in 2025 weighed heavily on business investment. Canada’s retains a structural advantage, one of the lowest effective tariff rates among U.S. trading partners, positioning the country to capture greater trade share as supply chains normalize.

Meanwhile, conditions are improving for the domestic economy. The labor market weakened notably in the first half of 2025 but staged a strong rebound in the second half, supported by slowing labor supply growth and trade policy stabilization. However, part of this recovery reflected an increase in part-time employment and a decline in the labor force participation rate.

Meanwhile, GDP figures for 2023 and 2024 were significantly revised upward, driven by stronger consumer spending and business investment. These revisions boosted productivity estimates and presented a more resilient growth outlook. In addition, real GDP grew by 2.6% in the third quarter, though this expansion was largely fueled by lower imports and higher government spending rather than a broad-based recovery.

Moreover, Canada stands to gain from the anticipated upswing in U.S. economic growth. Vanguard projects U.S. real GDP to accelerate to approximately 2.25% in 2026, with a substantial 60% probability of reaching 3% growth in the coming years, significantly above most consensus and central bank forecasts. This robust outlook is underpinned by accelerating AI-driven capital investment and supportive fiscal policy measures.

Taken together, these dynamics suggest Canada will outperform consensus expectations. We expect real GDP growth of around 1.6% in 2026, supported by resilient consumption, improving labor conditions, fiscal stimulus, a competitive trade position, and a favorable policy mix. Inflation should be contained in the mid-2% range, allowing the Bank of Canada (BoC) to maintain an accommodative stance without jeopardizing price stability. While risks persist, particularly around U.S.MCA developments and oil price volatility, Canada’s structural strengths and pragmatic policy approach point to continued resilience as global conditions stabilize and investment momentum builds.

Monetary policy

At its December 10 meeting, the BoC opted to maintain its policy rate at 2.25%, positioning it at the lower end of the estimated neutral range. This decision reflected several encouraging economic signals including a declining unemployment rate, robust Q3 GDP growth of 2.6%, further boosted by substantial upward revisions, and elevated core inflation at 2.8%.¹ Governor Tiff Macklem emphasized that the current rate is “about the right level to keep inflation close to 2% while helping the economy through this period of structural adjustment.”

Canada’s output gap has narrowed, reflecting both a decline in unemployment and upward revisions to GDP. At the same time, potential output has increased due to sizable annual upgrades in productivity growth. Each year’s rate from 2022 to 2024 was raised by 0.7 percentage points, driven by stronger consumer spending and business investment than previously estimated.

While higher potential GDP would typically imply greater economic slack, the offsetting effect of improved productivity means slack has actually diminished. On balance, reduced slack suggests the Bank of Canada should proceed cautiously with rate cuts, as easing too aggressively could risk overheating an economy now operating closer to full capacity. Therefore, the BoC will be cautious about further cutting.

As we have mentioned in our previous outlooks, Canadian fiscal policy initiatives such as large-scale infrastructure spending, housing programs, clean economy tax credits, and defence commitments will set a floor on how low interest rates can fall because they inject significant and sustained demand into the economy. With fiscal stimulus supporting growth and employment, the Bank of Canada will have less need to cut rates aggressively to spur activity.

Recently, expectations for a rate hike in Canada during the latter half of 2026 have increased. However, this scenario is unlikely for several reasons. First, labor market dynamics reveal that the drop in unemployment to 6.5% in November was largely driven by part-time job gains and a decline in labor force participation, rather than broad-based employment strength. Second, trade uncertainty persists, with businesses remaining cautious about capital investment. Most importantly, inflation is expected to moderate as retaliatory tariffs will take time to filter through the economy, falling rents are set to ease shelter inflation, and stalled population growth is likely to temper overall price pressures.

Figure 2 highlights the policy rate gap between the U.S. and Canada, which reached its widest point prior to the Federal Reserve’s 25 bps hike on December 10. We expect this differential to narrow slightly in 2026 as the Bank of Canada holds rates steady at 2.25%, while the Fed has limited room to cut below its estimated neutral level of about 3.5%, given resilient U.S. growth and persistent inflation pressures. Our forecast places the Fed’s policy rate at 3.5% by year-end 2026. This trajectory should provide underlying support for the Canadian dollar.

Inflation

Headline inflation (CPI) held steady at 2.2% in November, even as food prices surged 4.7% year-over-year, the fastest pace in nearly two years. Severe weather, U.S. tariffs on coffee producers impacting supply chains, and a reduction in cattle herds have been key drivers, with the sharpest effects seen in frozen beef and coffee.

The Bank of Canada’s preferred core measures, CPI-median and CPI-trim, eased by 20 basis points to 2.8%. Meanwhile, the three-month moving average of seasonally adjusted core inflation is trending close to the Bank’s 2% target on an annualized basis, with CPI-trim at 2.4% and CPI-median at 2.2%.

Headline inflation in 2026 is expected to remain volatile, driven by food and energy price fluctuations and tax-related base effects stemming from the GST/HST holiday that ran from December 14, 2024, to February 15, 2025. Oil price swings could further amplify this volatility. Additionally, stricter procurement rules or sector-specific concessions during the mid-2026 CU.S.MA joint review could introduce cost-push pressures through higher import costs and supply chain disruptions

Core inflation is projected to remain anchored in the mid-2% range, enabling the Bank of Canada to sustain an accommodative policy stance without jeopardizing price stability. We expect core inflation to end 2026 near 2.3%, supported by several disinflationary factors.

Slowing population growth should ease housing demand, exerting downward pressure on rents. The phased removal of retaliatory tariffs under CU.S.MA will gradually alleviate cost pressures on imported goods and manufacturing supply chains, tempering inflation in core goods categories.

Additionally, a stronger Canadian dollar has already reduced import prices and is anticipated to remain resilient through 2026, reinforcing the cooling trend. On the labor market front, as shown in Figure 3, the number of Canadians experiencing long-term unemployment has stabilized at an elevated level since mid‑2023, adding slack to the economy and contributing to weaker wage growth and subdued consumer spending, further dampening core inflation.

Core inflation will also be impacted by fiscal spending tabled in the Canadian budget. It will put mild upward pressure on core inflation, particularly beyond 2026, as stimulus-driven demand interacts with structural constraints. Near-term, inflation remains contained due to offsetting disinflationary forces, but risks tilt toward the upside if productivity improvements lag.

Figure 4 shows inflation measures easing in November, with CPI-median and CPI-trim declining to roughly 2.8% from 3.0% in October, indicating that underlying price pressures are moving closer to the Bank of Canada’s target range. This moderation is expected to persist into 2026.

Next time: The outlook for Canada’s GDP growth and labour markets in 2026.

Ashish Dewan CFA, CFP is Senior Investment Strategist at Vanguard Investments Canada. Excerpted from Vanguard’s “Canada 2026 Outlook.”

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