As we enter a New Year, the Canadian economy continues to confront trade uncertainty, as U.S. tariff policies impact business sentiment and export activity. At the same time, the labour market has weakened from its post-pandemic highs, economic growth has slowed, and home prices have cooled under the weight of higher borrowing costs and affordability constraints. Against this backdrop, the Bank of Canada (BoC) faces growing pressure to support demand without reigniting inflation.

In contrast to the U.S. Federal Reserve (Fed), the BoC acted aggressively throughout 2024 and 2025, delivering pre-emptive interest rate cuts as inflation eased and growth momentum softened. Those early moves place Canada on a different policy path than the United States, as timing and economic conditions should make the Fed the relative dove in 2026.

Why the BoC Held Rates While the Fed Cut

After cutting interest rates in October 2025, the BoC held its overnight lending rate steady at 2.25% in December. Conversely, the Fed continued its gradual rate-cut cycle, reducing the federal funds rate to 3.75%.

The divergence stems in large part from the BoC’s earlier and more extensive rate cuts in 2024 and 2025. By mid-2025, the Bank had already trimmed its policy rate significantly—cutting rates repeatedly before choosing to pause and assess incoming data. And because the BoC had already delivered multiple cuts, the marginal impact of additional reductions was lower. 

Moreover, with an interest rate differential of 150 basis points at the end of 2025, the spread between U.S. and Canadian interest rates was already near levels that marked historical reversals. For context, the differential peaked at 75 basis points in 2000 and 250 basis points in 1997.

Labour Market Implications

Because maximum employment is the second half of the BoC and Fed’s dual mandates (the first is inflation), labour market performance is a key indicator. And with the U.S. unemployment rate hitting a 2025 high of 4.6% in November, it supported further easing from the Fed. Yet, the Canadian unemployment rate fell from 7.1% in September 2025 to 6.5% in November, making it easier for the BoC to hold rates steady.

Historical Divergences Between the BoC and Fed

It is not unprecedented for the BoC and the Fed to chart different monetary policy paths, and diverging economic conditions are typically the primary driver. 

For example, the Mexican peso crisis in 1994-1995 caused the BoC to cut its policy rate from 8.1% to 3% as economic growth slowed dramatically, which widened the output gap and put downward pressure on inflation. On the flip side, the collapse of billion-dollar hedge fund Long-Term Capital Management in 1998 barely impacted U.S. economic growth. The Fed responded by raising interest rates later, and with the BoC following suit at a slower pace, the Canadian dollar suffered mightily as the interest rate differential moved in the Fed’s favour.

Interestingly, when current Prime Minister Mark Carney was the BoC Governer in 2008, he began his tenure with a 50 basis point rate cut in March. And by April 2009, he reduced the overnight lending rate to near-zero in response to the global financial crisis. Yet, the Fed moved at a slower pace despite the banking crisis unfolding north of the border. As such, even when both institutions chart similar courses, they can move at different speeds.

Inflation, Tariffs, and BoC’s Decision-Making Process

Inflation remains a central concern for the BoC’s 2026 policy outlook. By late 2025, Canadian headline inflation was around 2.2%, close to the BoC’s target of 2%, with core measures remaining within or near desired ranges. 

The BoC has emphasized the need to monitor upside pressures carefully, as further rate cuts could risk above-target data, particularly if cost pressures re-emerge due to factors like tariffs and currency depreciation.

Tariff Impacts 

Tariffs imposed by the United States and retaliatory measures by Canada have introduced inflation uncertainty. And while some economists suggest tariffs can lower inflation, the unpredictability complicates the BoC’s forecasting ability.

BoC Governor Tiff Macklem noted in December 2025 that “steep U.S. tariffs on steel, aluminum, autos and lumber have hit these sectors hard, and uncertainty about U.S. trade policy is weighing on business investment more broadly.”

Thus, it’s a careful balancing act between cost increases and demand destruction, so the BoC will likely act cautiously as long as the Canadian economy remains resilient.

The Canadian Dollar

Because currency movements influence inflation, trade balances, and economic growth, the behaviour of the USD/CAD is critical. When the Canadian dollar weakens against the U.S. dollar, imported goods become more expensive, putting upward pressure on prices and potentially complicating inflation. In contrast, a stronger Canadian dollar can ease inflation but hurt foreign demand and export activity.

Consequently, while the BoC must balance the domestic backdrop with potential exchange rate spillovers, the behaviour of the Canadian dollar will likely be a secondary consideration after inflation and employment.

2026 Interest Rate Outlook

The BoC is likely to continue its data-dependent approach in 2026:

  • Inflation Expectations: With inflation near target but not decisively below it, the BoC may opt to hold its policy rate steady until there is clear evidence that pricing pressures remain under control without additional tightening.
  • Economic Growth: With GDP growth slowing, but not collapsing, the right policy approach may be to save future cuts for when the economy needs a significant boost.
  • Labour Market: Resilient employment reduces the need for further cuts, and with Canadian job postings on Indeed rising in recent months, further weakness is likely needed for more easing. 
  • Tariffs and Exchange Rates: Ongoing trade friction and potential volatility in currency markets complicate the risks outlined above. If a U.S.-Canada trade deal emerges in 2026, the BoC may need to hike rates if underperforming sectors prosper once again.

Conclusion

The divergence in monetary policy between the Bank of Canada and the U.S. Federal Reserve underscores the complex interplay of domestic economic conditions, inflation dynamics, labour market trends, exchange rate movements, and geopolitical risks, like tariffs. 

As a result, while the Fed has intensified its rate-cutting cycle in response to softening employment indicators, the BoC is already ahead of the game due to its aggressive cuts in 2024 and 2025. Therefore, the BoC is likely to maintain a cautious, data-dependent approach in 2026 — one that supports its dual mandate of maximum employment and price stability for all Canadian.