The Bank of Canada left its benchmark interest rate at 2.25 per cent, despite the present danger of faster inflation. Governor Tiff Macklem said he’s prepared to “look through” immediate commodity price increases caused by the Iran war because Canada’s economy might be weaker than policymakers thought.

War planning: There was little doubt about the central bank’s next move. When Macklem dropped the policy rate to 2.25 per cent in October, he said he intended to leave it there until he detected a material shift in economic conditions. New data this week showed year-over-year price changes are around two per cent, the central bank’s target. There was no reason to change course.

The Iran war could force Macklem out of cruise control. The governor said surging prices for gasoline and other fuels “will push up inflation in the short term.” The central bank can live with that. The question is what supply disruptions portend for the medium term. “Governing Council will look through the war’s immediate impact on inflation but if energy prices stay high, we will not let their effects broaden and become persistent inflation,” Macklem said. 

Weak, weaker, weakness: The central bank can resist raising interest rates in the face of an obvious inflation threat because the economy is troubled. Macklem used a variation of the word “weak” six times while describing how things have changed since the Bank of Canada’s forecast in January. Economic growth was “weaker” than anticipated in the fourth quarter; recent trade data suggest “weakness” in exports; and even though government and household spending remained a source of internal demand, housing was “weak” and the latest hiring numbers suggest the labour market is soft. 

“The Canadian economy remains in excess supply and is growing slowly,” Macklem said.  

The reference to “excess supply” is important. The Bank of Canada thinks the country’s providers of goods and services have idle capacity because of a lack of demand. That makes this supply shock different from what happened after the COVID-19 pandemic, when inflation soared to the highest in decades. The post-pandemic period was a moment of “excess demand” that suppliers couldn’t meet, so they raised prices. It’s a little perverse, but Canada’s economic weakness will absorb some of the coming inflation because producers’ ability to raise prices will be constrained by an existing lack of buyers. 

New dilemma: Things were uncertain enough before the U.S. and Israel attacked Iran and killed its leaders. Macklem noted the future of the North American trade agreement remains a “big unknown,” while “shifting trade relationships,” artificial intelligence and changing demographics continue to work in the background. 

Rising inflation amid slower growth adds stagflation to the threat menu. It’s not impossible that Macklem could find himself raising interest rates even as economic growth stalls. “Uncertainy is acute,” he said.