Try Fund Library Premium
For Free with a 30 day trial!
As the first quarter of 2026 unfolds, Canada finds itself navigating a familiar but evolving set of geopolitical and trade-related headwinds that continue to complicate its domestic economic outlook. While most Canadian exports to the U.S. remain tariff-exempt under USMCA rules, the persistence of trade policy uncertainty has reinforced a cautious stance among firms, suppressing business confidence and non-residential investment.
Meanwhile, elevated oil prices stemming from the Iran-related conflict are likely to provide a modest tailwind for Canada, given its status as a net energy exporter. While higher energy costs may push core inflation higher and weigh on household discretionary spending, the overall terms-of-trade effect should remain supportive for the Canadian economy. The Bank of Canada (BoC) could be forced to tighten policy if inflation reaccelerates or if geopolitical developments, including the conflict in the Middle East, begin to lift inflation expectations. With yields having moved higher in Canada, some tightening related to the Middle East crisis has already occurred, even as Canadian labour markets continue to soften.
We conducted scenario analysis to assess the macroeconomic implications of higher oil prices, varying assumptions around both the duration of the Middle East conflict and the resulting impact on GDP, headline inflation, and core inflation. Across all three scenarios, Canada avoids a recession. Our analysis also reveals that a sustained oil price of $150 per barrel throughout 2026 would be sufficient to push the U.S. economy into recession.
Figure below summarizes the expected economic effects of elevated oil prices. Our assessment is informed by historical experience and explicitly accounts for offsetting forces from fiscal and monetary policy. For Canada, the key insight is that while higher oil prices lift GDP in all three scenarios, the net growth benefit peaks under the moderate scenario. Prolonged periods of high oil prices disproportionately benefit energy-producing regions but weigh on aggregate demand elsewhere in the economy, ultimately limiting overall growth.
Fiscal policy will add a modest tailwind through targeted sectoral initiatives and ongoing infrastructure programs. Paired with expectations for above-trend global growth, we forecast Canadian real GDP to expand by 1.8% in 2026. Core inflation eased through late 2025, giving the Bank of Canada room to cut rates by a cumulative 100 basis points last year. We expect the policy rate to stay at the lower end of the neutral rate at 2.25% throughout the year despite the markets pricing in rate hikes for the back half of 2026 as shown in Figure 2, partly driven by concerns that the oil-related inflation might force the BoC’s hand. We expect the BoC to look through supply-driven price shocks as long as inflation expectations remain anchored.
Canada’s job losses in January and February 2026 rank among the most severe outside of major recessions. We expect the unemployment rate to edge lower over the coming quarters, driven less by a rebound in hiring and more by declining labour force participation, an early signal of the demographic slowdown likely to shape the labour market in the years ahead. Real wage growth and a relatively modest pace of further job losses should also help stabilize labour market conditions.
At its March 18 meeting, the BoC opted to maintain its policy rate at 2.25%, indicating that headline inflation had eased to 1.8% in February and that the Canadian economy was operating in a state of excess supply as evident with a 0.6% GDP contraction in Q4 2025 and a labour market that was soft. Monetary policy is already sufficiently restrictive due also to weak credit growth, sluggish housing market activity and many households have to refinance their mortgage at a much higher rate in 2026. With these dynamics in mind, officials see little need to raise rates further.
Our view is that the markets are incorrectly pricing in too many hikes as these signs argue against tightening monetary policy.
In discussing the potential for a rate cut, BoC Governor Tiff Macklem emphasized that the central bank remains prepared to look through the immediate inflationary effects stemming from the conflict in the Middle East provided these pressures do not translate into persistent inflation. The war-driven surge in global oil prices has temporarily elevated headline inflation in Canada, as well as in other regions. The BoC has indicated its willingness to tolerate a near-term rise in inflation above its 3% upper target band, so long as the increase is clearly attributable to transitory external shocks and long-term inflation expectations remain well-anchored.
Canada’s relatively moderate inflation backdrop affords the BoC greater policy flexibility compared with the United States. In this context, the BoC may be open to further rate cuts. However, such a move would depend on confirmation that the energy shock does not prove more severe or enduring than anticipated, nor lead to second-round effects on wages and inflation expectations.
Our assessment is that the Bank of Canada is unlikely to deliver additional rate cuts until there is greater clarity on both the duration and scope of the Middle East conflict, alongside more persistent and broad-based weakening in labour market conditions. A further constraint on the policy outlook is the inflationary impact of domestic fiscal policy. Large-scale infrastructure spending, housing initiatives, clean-economy tax incentives, and increased defence commitments are likely to place a structural floor under how far interest rates can be reduced.
The Bank will also be monitoring developments related to CUSMA, particularly as many investment decisions remain on hold ahead of the joint review, as well as assessing the risk of supply-chain disruptions stemming from the Middle East conflict. Taken together, these considerations underpin our baseline view that the Bank of Canada will maintain its current policy stance and keep rates on hold throughout 2026.
Headline inflation (CPI) has continued to ease and is now below the Bank of Canada’s 2% target, alongside signs of weakness in labour markets. CPI slowed to 1.8% year over year in February 2026 (see Figure 3), down from 2.3% in January, with the deceleration largely reflecting base-year effects tied to the expiration of the temporary GST/HST tax break, which ran from December 14, 2024, to February 15, 2025.
Because the tax relief applied to restaurant meals and beverages and ended partway through February last year, restaurant food prices remained elevated at 7.8% year over year. Even so, overall food inflation moderated to 5.4% in February, down from 7.3% in January, pointing to notable declines in meat prices.
Despite this easing, food inflation remains well above headline CPI and continues to be sensitive to energy prices, reflecting the sector’s reliance on fuel inputs and fertilizer production. A prolonged conflict in the Middle East could add upward pressure to food inflation, and adverse weather conditions may compound these effects by increasing food and fertilizer costs.
Excluding volatile food and energy components, Canada’s underlying inflation is close to target and continues to ease. The average of CPI-trim and CPI-median, the Bank of Canada’s preferred core measures, slowed to 2.3% in February 2026, down from 2.45% in January.
Our analysis suggests that a protracted conflict in the Middle East would raise core inflation by roughly 30 basis points (see Figure 1), while headline inflation could increase by about 75 basis points. Notably, the three-month annualized average of CPI-trim and CPI-median has fallen below 1%, pointing to disinflationary momentum and meaningful progress on inflation, which would give the Bank of Canada greater scope to ease policy should labour market conditions deteriorate further.
Soft domestic demand, together with well-anchored inflation expectations, should help keep core inflation contained. As a result, an energy-driven pickup in inflation is unlikely to trigger a broader or persistent inflationary spiral, provided wage growth and business pricing behaviour do not respond aggressively to what is expected to be a temporary rise in energy costs.
Beyond the risk of a prolonged conflict in the Middle East, renewed global supply-chain disruptions and rising labour costs represent upside risks to inflation. Mortgage interest costs have already increased as a result of past interest-rate hikes. Should the Bank of Canada tighten policy further, higher borrowing costs could push up mortgage interest costs and therefore headline inflation higher. During the 2022-23 hiking cycle, mortgage interest cost inflation at times contributed close to one percentage point to headline CPI, despite its relatively modest weight in the index.1
We expect year-end core inflation to be approximately 2.2% unless the conflict in the Middle East lasts longer than three months or other external shocks emerge.
Next time: The outlook for Canada’s GDP growth and labour markets in Q2.
Ashish Dewan CFA, CFP is Senior Investment Strategist at Vanguard Investments Canada. Excerpted from Vanguard’s "Canada 2026 Q2 Outlook: Reslience amid geopolitical crosscurrents."
Notes
1. Bloomberg
Disclaimer
Content © 2026 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared April 9, 2026, on the “Insights” page of the Vanguard Group, Inc.’s website. Used with permission. All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Investments in stocks and bonds issued by non- U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
Image: iStock.com/DavidByronKeener
Try Fund Library Premium
For Free with a 30 day trial!
Fund Library
