Market Update: Macklem says economy undergoing structural change, plays down chance of further rate cuts – Full Analysis

The Canadian economy is going through a profound structural transformation that could weigh on growth for years, but further interest rate cuts risk doing more harm than good, the Bank of Canada Governor Tiff Macklem said Thursday.

A combination of U.S. protectionism, artificial intelligence and a sharp slowdown in population growth is fundamentally changing the Canadian economy, Mr. Macklem said in a speech to a Bay Street audience in Toronto.

Canadian companies have begun to adjust to this new world. But this process will take “years, not quarters,” he said, with major risks if the economy fails to restructure.

“The transition could be faster than we expect, particularly if trade uncertainties ease and businesses move more boldly to invest in new technology, markets and products. But it could also be more painful than we’d like – particularly if the trade situation darkens or other shocks disrupt the economy,” he said.

The Governor urged business leaders and politicians to “lean into” these forces by developing new international markets and adopting artificial intelligence tools to boost productivity.

But he was circumspect about the role the Bank of Canada can play during this period of disruption, offering a somewhat hawkish take on monetary policy that reinforced market expectations that the central bank will remain on hold through 2026.

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Last week, the bank held its benchmark interest rate steady at 2.25 per cent for the second consecutive time. And it signalled that further cuts are unlikely unless there is a significant change to the economic outlook.

“We have to be careful not to misdiagnose economic weakness. Monetary policy should not try to compensate for lost supply,” Mr. Macklem said Thursday, expanding on the bank’s current thinking about interest rates, economic growth and inflation.

If the economy was going through a regular cyclical downturn, then it might make sense to stimulate demand by easing interest rates, he said. But if economic weakness is being caused by structural forces – such as a reordering of North American supply chains or sudden drop in immigration levels – then the argument shifts.

“Lowering interest rates in the face of weak economic activity risks stoking future inflation if the weakness is due to lower productive capacity rather than a cyclical downturn in demand. And there is also a risk that overstimulating demand when the problem is structural could delay needed structural change,” he said.

Annual consumer price index growth has been inside the bank’s 1-per-cent to 3-per-cent control band for a year, and the bank is forecasting that it will remain around 2 per cent over the next year. Still, Mr. Macklem’s comment suggests he remains wary of upside risks to inflation, even as the economy struggles to churn out much growth.

Royce Mendes, head of macro strategy at Desjardins, said Mr. Macklem’s speech stood in stark contrast to the views of Kevin Warsh, U.S. President Donald Trump’s pick to be the next chair of the U.S. Federal Reserve. Mr. Warsh has argued that strong productivity growth from the adoption of artificial intelligence should allow the Fed to ease rates without stoking inflation.

“The freshly-nominated Fed Chair believes that monetary policy can help accelerate the structural transition underway, with lower interest rates supporting business spending on productivity-enhancing investments. Only time will tell which central banker is correct,” Mr. Mendes wrote in a note to clients.

“However, with inflationary pressures already very tame in Canada, Macklem sounded unnecessarily hawkish on the outlook for rates,” Mr. Mendes added.

The Canadian economy has proven more resilient over the past year than many economists expected, but it remains in a funk. Exports are down sharply, unemployment is elevated and businesses are postponing investment and hiring decisions.

Canada’s real gross domestic product flatlined in November and appears to have contracted slightly in the fourth quarter, according to GDP numbers published by Statistics Canada last week.

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Looking ahead, the Bank of Canada forecast muted GDP growth of 1.1 per cent in 2026 and 1.5 per cent in 2027.

“In our baseline forecast, the spillover effects from the trade shock and uncertainty gradually dissipate and the economy recovers from the cyclical weakness. But the path for potential output is lower because of increased trade friction and slower population growth,” Mr. Macklem said.

A great deal depends on U.S. trade policy, particularly the outcome of the upcoming review of the North American free-trade pact, known as USMCA.

Most Canadian exports remain exempt from U.S. tariffs, owing to a carve-out for products that comply with trade-agreement rules. If that exemption were to end, the effective tariff rate would rise sharply, with grave consequences for the Canadian economy.

Mr. Macklem said that Canadian companies, supported by government fiscal and industrial policy, have begun to make the adjustments necessary to thrive in a rapidly changing world. But it’s still early going.

Canadian exports to countries other than the U.S. have risen over the past year. But this has been driven by certain idiosyncratic factors, such as the surge in the price of gold, and so far companies are mostly shipping more products to existing clients rather than developing new overseas markets.

The story is similar for the adoption of artificial intelligence, which “looks to be increasing in Canada but remains modest,” Mr. Macklem said.

Only 8 per cent of businesses surveyed by the Bank of Canada reported significant AI use in their operations, while another 11 per cent reported plans to use AI over the next year, he said.

Going forward, Canada’s ability to diversify trade and adopt new technologies will determine the country’s future prosperity, he said.

“We can be victims of U.S. tariffs and AI disruption, or we can lean into structural change, expand our internal market, diversify our trade, embrace new technology and raise our productivity.”