Tiff Macklem: Tariffs, structural change and monetary policy
Central bank: boc | Type: speech | Date: 2025-02-21

Remarks by Tiff Macklem Governor of the Bank of Canada Mississauga Board of Trade Oakville Chamber of Commerce February 21, 2025 Mississauga,

Ontario

## Tariffs, structural change and monetary policy

## IntroductionGood afternoon.

It's a pleasure

to be here.

I want to thank the Mississauga

Board of Trade and the Oakville Chamber of Commerce for inviting me.When I accepted this invitation,

months ago, I intended

to use this opportunity to launch the renewal process for our monetary policy framework.

The framework sets out the goal for monetary policy-to maintain price stability over time.

In simple terms, we aim for a 2% inflation target, so inflation remains within a range of 1% to 3% most of the time.

We renew the framework, in agreement with the Government of Canada, every five years.

This is a strength of our system.

It gives us the opportunity

to review performance and consider whether the framework remains the best one for the future.That was my speech topic until President

Trump announced

significant and broad-based

tariffs on Canadian exports.

While the new tariffs have not taken effect yet, the uncertainty around US trade policy is already affecting our economy.

And if the United States starts a protracted trade conflict, the consequences

could be severe.

I know this is foremost on everyone's mind.

That's why I've adjusted

my remarks.President

Trump wants to use tariffs as an instrument of US policy.

What that means for the global economy and for the Canada-US trade relationship

is highly uncertain.

We don't know what tariffs will be imposed, when they'll start, how long they'll last-or even really to what end.

We also don't know how Canada and other countries will respond.

And even when we know more, it will be hard to predict the economic impacts because we haven't experienced such broadbased tariffs since the 1930s.What looks inescapable,

however, is that a structural change is upon us.

Increased trade friction with the United States is a new reality.

While there arestill

more questions

than answers, I will use my remarks to speak to some of the key questions:What could this structural change look like?How would a protracted trade conflict affect the Canadian economy in both the short run and the long run?What can monetary policy do and not do?What could Canada do-beyond the scope of monetary policy-to compensate for at least some of the consequences

of increased trade friction with the United States?I'll then

turn back to my original plan and launch the latest review of our monetary policy framework.

The future looks different than the past, and it's critical we get going on this review.

## The benefits of free trade between Canada and the United StatesBefore I explain how trade friction will hurt our economy, let me explain how open trade has helped both Canada and the United States.After World War II, the allied nations created the Bretton Woods institutions

and progressively

reduced tariffs.

They wanted to avoid the protectionism and instability

of the Great Depression.

And they believed that economic cooperation-including

open trade-was the best way to maintain peace and build prosperity.In 1965, Canada and the United States signed the Canada-United

States Automotive Products Agreement ,

better

known as the Auto Pact.

Open trade in the automotive sector allowed for economies of scale and specialization.

Productivity went up and prices for motor vehicles went down in both countries. 1The success of the Auto Pact prompted more appetite

for open trade.

The Canada-US Free Trade Agreement ,

signed in 1988, broadened

the economic gains considerably.

Manufacturing productivity in Canada, for example, increased by about 14%. 2In 1994, the trade relationship

expanded further to include Mexico with the North American Free Trade Agreement .

And in 2020, this agreement was updated

and renewed during the first Trump presidency.

The durability

of this trade agreement speaks to the benefits to all three countries.For roughly the past 60 years, our bilateral

trade with the United States has increased.

Today, about three-quarters

of Canada's

goods exports flow to the United States.

Canada is the number one export destination

for the United States-and

the largest export destination

partner for 32 of the 50 states.

Canada's

biggest export to the United States is energy.

Canadian oil, natural gas, gasoline,

and electricity literally fuel the US economy at a price no one else1

K.

Charbonneau, D. de Munnik and L.

Murphy, 'Canada's Experience with Trade Policy,' Bank of Canada Staff Discussion Paper No. 2018-1 (January 2018).2

A.

Lileeva and D.

Trefler, 'Improved Access to Foreign Markets Raises Plant-Level Productivity…For Some Plants,' Quarterly Journal of Economics 125, no. 3 (August 2010): 1051-1099.in the world can provide.

And if we exclude our energy exports, the United States actually has a trade surplus

with Canada ( Chart 1 ).Open trade between Canada and the United States has benefitted both countries, increasing

efficiency, spurring investment, boosting

productivity and raising standards

of living.

A significant increase in tariffs will kick all this into reverse.Chart 1: Excluding energy, Canada has had a trade deficit with the United States since 2007Canada-UStrade balanceinCan$billions, annualdataNote: Canada-US trade balance excluding energy uses customs data for energy trade, while Canada-US trade balance uses balance of payments data.Sources: Statistics Canada via Haver and Bank of Canada calculationsAnalyticsLast observation: 2023

## What structural change looks likeThe economic consequences

of a protracted trade conflict would be severe.

But it would be a very different shock than the COVID-19 shock.

In the pandemic, we had a steep recession followed by a rapid recovery as the economy reopened.

This time, if tariffs are long-lasting

and broad-based,

there won't be a bounceback.

We may eventually regain our current rate of growth, but the level of output would be permanently lower.

It's more than a shock-it's a structural change.To get an estimate of how much lower production and incomes would be, you need an economic model.

As described in our January Monetary Policy Report (MPR), we have combined a multi-sector, multi-country trade model with our main macroeconomic models of the Canadian economy to examine the impacts of a protracted trade conflict. 3

I do want to emphasize

that models are imperfect at the best of times, and we need to be more cautious than usual because of the3

See Bank of Canada, 'In focus: Evaluating the potential impacts of US tariffs,' Monetary Policy Report (January 2025).lack of historical experience with big increases

in tariffs.

So please

do not interpret these results as a forecast-but more as an illustration

of the economic impacts.With that caveat, Chart 2 shows an estimate of the long-run effect of higher tariffs.

The grey line shows the Bank's projection from our January MPR, which is our base-case projection without tariffs. 4

Economic output is climbing steadily.

The blue line

shows the impact of the anticipated

tariffs based on the Executive Order signed by President Trump on February 1, plus retaliatory tariffs by Canada.

That executive order calls for 25% tariffs on non-energy goods exports and 10% on energy exports to the United States. 5

Based on this scenario, economic output initially falls, then it steadies

and begins to grow again, but on a path that is about 2½% lower.Chart 2: High tariffs permanently lower the path for outputSources: Statistics Canada and Bank of Canada calculations, estimates and projections Last data plotted: 2030Q14

To be more precise, the grey line through 2026 is the MPR projection for gross domestic product.

And this forecast has been extended assuming potential output growth of about 2% on average thereafter.5

This scenario reflects recent developments and updates the more severe scenario presented in the January MPR.

The Executive Order signed by President Trump on February 1 imposes new tariffs of 25% on all the goods, excluding energy, that it imports from Canada; 10% on all the energy products from Canada; 25% on all the goods it imports from Mexico; and an additional 10% on all the goods it imports from China.

In addition, we add the retaliatory 25% tariffs on Can$155 billion worth of US imports proposed by the Canadian government.

Mexico is assumed to retaliate by imposing a 25% tariff on all goods it imports from the United States.

China is expected to retaliate by imposing tariffs in the range of 10% to 15% on less than one-tenth of its imports from the United States.

Because our model scenario is quarterly, the new tariffs begin in the second quarter.

## How tariffs hurt economic activity and boost inflation in the short runModels can also help us understand

the impact of tariffs in the short run.

These effects are expressed

relative to the projection we published

in January.The first thing we would see is a marked decline in exports.

As Canadian goods become more expensive, US demand for those goods

would decline.

A lower Canadian dollar would provide a partial offset.

In our model with the scenario based on the February 1 Executive Order, exports

fall by 8½% in the year after the tariffs take effect ( Chart 3 ).

Canadian

exporters respond

by cutting production and laying off workers.Chart 3: Exports and business investment would fall sharply after tariffs are imposedPercentage change compared with the January projection, quarterly dataSources: Bank of Canada calculations, estimates and projectionsLast data plotted: 203001With exports to the United States accounting for roughly one-quarter

of our national

income, the shock would be felt across Canada.Lower export revenues would reduce household

income.

And retaliatory tariffs would raise the prices of many consumer goods.

As a result,

consumer spending on everything from cars to entertainment and housing would slow.

In this scenario, consumption declines by more than 2% by mid-2027 ( Chart 4 ). 66

In this scenario, governments are assumed to provide some additional support to households, transferring half the new tariff revenue to them.

## Chart 4: Consumption and output weaken until mid-2027Percentage change compared with the January projection, quarterly dataSources: Bank of Canada calculations, estimates and projectionsLast data plotted: 203001With export and consumer demand weakening, Canadian businesses

would also cut their

investment spending.

And higher costs and lower profit margins

would restrain investment further.

With retaliatory tariffs on some goods and a lower Canadian dollar, businesses

will face higher import costs-Canadian

businesses buy roughly half of their machinery and equipment from the United States.

In addition,

profit margins are squeezed

because the higher costs associated

with tariffs on imported consumer goods get passed

on to prices in Canada gradually.

Lower sales, higher costs and reduced profit margins all combine to pull down business

investment substantially.

All told, investment declines by almost 12% by early 2026, one year after tariffs are imposed ( Chart 3 ).What would this all mean for economic growth?

In our January projection with no tariffs, we forecast growth of about 1.8% in both 2025 and 2026.

But in the tariff scenario, the level of Canadian output falls almost 3% over two years.

That implies tariffs would all but wipe out growth in the economy for those two years.Finally, a trade conflict would push up prices, even as demand weakens.

Retaliatory tariffs on US exports to Canada feed into the consumer price index (CPI).

Roughly 13% of Canada's CPI basket is made up of goods imported from the United States.

The depreciation

of the Canadian dollar also increases the cost of all imported goods and services.

Finally, integrated

supply chains mean tariffs can add costs at multiple stages of production.Chart 5: Total CPI inflation rises as upward pressure from tariffs outweighs the downward pressure from excess supplyPercentage point difference in the year-over-year inflation rate compared with the January projection, quarterly dataSources: Bank of Canada calculations, estimates and projectionsLast data plotted: 203001In our tariff scenario, the factors pushing

prices up more than offset the downward price pressure

from weaker demand, so inflation rises ( Chart 5 ).

In January, the Bank projected that inflation would remain close to the 2% target for the next two years.

Tariffs would temporarily push inflation above 2%. 7

## What monetary policy can and cannot doIf the economy is on a lower path and there's

upward pressure

on inflation, what's the response

from monetary policy and the Bank of Canada?What the Bank can do is help the economy adjust.

With inflation

now back around the 2% target, we are better positioned

to contribute to economic stability.

However, with a single instrument-our

policy interest rate-we can't lean against

weaker output and higher inflation at the same time.

As we consider our monetary policy response,

we will need to carefully assess

the downward pressure

on inflation from weakness in the economy and weigh that against the upward pressure

on inflation from higher import prices and supply chain disruptions.Unlike the pandemic, if tariffs persist there will be no economic bounce-back.

Long-lasting

tariffs mean lower potential

output because our economy works less7

As shown in the January MPR, the path for inflation is quite sensitive to how quickly businesses pass through higher costs to consumer prices.

Based on historical experience, this baseline calibration assumes full pass-through over three years, which is why year-over-year inflation is higher for three to four years.

As shown in the sensitivity analysis in the MPR, faster pass-through means inflation would rise by more but also come back down more quickly.

The overall price level increase is similar in both cases.efficiently.

Monetary policy cannot restore the lost supply.

At most, it can smooth the decline in demand.The sharp fall in exports and investment when tariffs are imposed, combined with weaker consumption, means that initially demand would fall more than potential output, creating excess supply in the economy.

Provided the inflationary impact of tariffs is not too big, monetary policy can help smooth the adjustment

by supporting

demand so it doesn't

weaken too much more than supply.

But how much support monetary policy can provide is constrained

by the need to control inflation.The initial impact of tariffs is a one-time rise in the level of consumer prices.

Monetary policy cannot change that.

What monetary policy can-and must-do is ensure that higher prices do not become ongoing inflation.

This means making sure that households

and businesses

continue to expect inflation to remain well anchored on the 2% target.

Simply put, monetary policy needs to ensure the increase in inflation is temporary.

## Strengthening Canada's economic unionI hope-we all hope-Canada

can continue open trade with the United States.

A trusted open trade relationship

benefits both countries.

But if we are faced with a prolonged

trade conflict, the only way to offset this negative structural change is with a positive structural

change.Structural policies

are appropriately

the responsibility

of elected governments and parliaments-not

the Bank of Canada.

So I will tread lightly here.The Bank has previously highlighted

Canada's

productivity challenge. 8

And it's good to see more focus by federal and provincial governments on structural reforms to increase productivity and investment by strengthening

our economic union. 9Removing rules that restrict interprovincial trade and harmonizing

or mutually recognizing

provincial regulations

could provide some offset to increased trade friction with the United States. 10

Provinces could also make it easier for workers to move within Canada by mutually recognizing

different labour accreditations.

There is also scope for all levels of government to reduce the timelines

and uncertainty related to regulatory approvals.

And better east-west transportation links would make trade within Canada less expensive-and

help get Canadian products to overseas markets.8

See C.

Rogers, 'Time to break the glass: Fixing Canada's productivity problem' (speech delivered to the Halifax Partnership, Halifax, Nova Scotia, March 26, 2024); and T.

Macklem in 'The Standing Senate Committee on Banking, Commerce and the Economy - Evidence,' minutes of proceedings, Ottawa, Ontario (October 30, 2024).9

Intergovernmental Affairs Canada, 'Committee on Internal Trade discusses bold actions to enhance Canada's internal market,' news release (January 31, 2025).10

Estimates from the International Monetary Fund suggest liberalization of internal trade in goods in Canada could significantly increase GDP per capita.

For more detail, see J.

A.

Alvarez, I.

Krznar and T.

Tombe, 'Internal Trade in Canada: Case for Liberalization,' IMF Working Paper No. 19/158 (July 22, 2019); and L.

Albrecht and T.

Tombe, 'Internal Trade, Productivity and Interconnected Industries: A Quantitative Analysis,' Canadian Journal of Economics 49 (1): 237-263

(February 2016).Again, it is not for the Bank of Canada to prescribe these policies or investments.

But higher productivity means higher potential

output and more capacity for growth without inflation.

As Canada confronts the reality of increased trade friction with the United States, a concerted focus on productivity has rarely been more important.

## Renewing our monetary policy frameworkIn some ways, the US tariff threat is part of a broader global economic shift.

The structural tailwinds

of peace, globalization

and demographics

that helped keep inflation

low are turning

into headwinds-and

the world looks increasingly shock prone.

Higher long-term interest rates, elevated sovereign

debt and slower economic growth have made the global economy more vulnerable.

Compounding these vulnerabilities

are war, rising trade protectionism and economic fragmentation.

Canada also has a structural supply challenge in its housing market.

For years, the supply of housing

has not kept up with demand, and housing

affordability has deteriorated.These shifts all have implications for inflation.

They may put more upward pressure

on prices, and a more shock-prone world means more volatility in inflation.

And that brings me to my original topic: the Bank's flexible inflationtargeting

framework.Since 1995, the 2% target has been jointly agreed with the Government of Canada.

This gives it political legitimacy and gives the Bank the operational independence

to conduct monetary policy.For 25 years leading

up to the pandemic, inflation was low and stable.

But the pandemic tested the framework like never before.

We faced huge shocks to both demand and supply, a deep recession

and a rapid rebound.

As the economy reopened,

inflation rose sharply, hitting 8%.

Guided by the framework, the Bank raised the policy rate forcefully to bring inflation down.

Since last summer, inflation

has been close to 2%, and we've cut our policy rate to keep it there.

In short, the framework was tested-and

it proved resilient.The measure of the framework's success is not only whether inflation is close to 2%.

It's also how the framework performs in the face of shocks, especially big ones.The next renewal of the framework is set for 2026, and the review begins

now.

Our focus in this review will be how we can improve the framework and its implementation

to best address

structural changes.

We will consider several questions.With more supply shocks, do we need a richer playbook for monetary policy?

The usual response

to supply shocks is to look through their temporary impact on inflation.

But we saw in the pandemic that supply shocks can be persistent,

and they can accumulate.

The best response

will depend

on the situation.In a world with more volatility, how should we measure underlying inflation?

No single measure of core inflation works for all circumstances.

What measures are most robust in a shock-prone world?

Should we focus on two or three preferred measures, or is a broader approach better?We also want to consider the interaction of monetary policy and housing.

Housing affordability is a major concern for Canadians,

and rising housing costs feed inflation.

But monetary policy cannot directly increase housing

supplythat's

an issue for elected governments at all levels.

Still, we must consider how monetary policy affects housing demand and supply and how the imbalance between them feeds into inflation in shelter

prices.The question

of housing market imbalances also matters for the measurement of underlying inflation.

Does persistently

high inflation in shelter prices distort our measures of core inflation?Finally, each time we've reviewed our framework we've asked about the inflation target itself.

In our five reviews since 1995, we've considered

whether 2% is the right target

and we've weighed alternatives,

including price-level targeting and nominal GDP targeting, among others.

Each time, we've concluded that 2% inflation

is the right target.

Canadians

have told us they don't want higher inflation.

They have also told us that the 2% target is well known and well understood.

That has helped anchor inflation expectations through thick and thin, including through the pandemic crisis.

With trade conflict on our doorstep,

we need to focus our resources on the most pressing

and important issues

for our framework review.

In my view, now is not the time to question

the anchor that has proven so effective in achieving price stability.

## ConclusionWe have covered a lot of ground, and it's time for me to conclude.Canada's

economy is on a better footing.

Inflation has returned to target, interest rates have come down substantially,

and household

spending

has strengthened.

But a new crisis is on the horizon.

If US tariffs play out as threatened,

the economic impact would be severe.

A protracted trade conflict would sharply reduce exports and investment.

It will cost jobs and boost inflation in the next few years and lower our standard of living in the long run.

The uncertainty alone is already causing harm.Central banks can do little to mitigate the damage

caused by a trade war.

Our role will be to balance the upside

risks to inflation from higher costs with the downside

risks from weaker demand.

Our focus will be to help smooth the painful adjustment

to a lower path for the economy while preventing price increases from becoming higher ongoing

inflation.The inflation-targeting

framework has proven both flexible and durable.

Its review every five years is an opportunity to reflect on what's working well and what could be improved.

The framework proved itself time and again, and the bar for change is high.But the world economy is shifting.

At the Bank of Canada, we are committed to ensuring

we are as prepared as possible

for the changes to come.Thank you.