Other economic indicators

Momentum is easing, but domestic demand remains a source of strength

The U.S. economy continues to expand, albeit at a more moderate pace than earlier this year. Real GDP growth slowed to an annualized 1.5% in the second quarter of 2026, compared with 2.1% in the first quarter, pointing to a gradual normalization in activity rather than a meaningful loss of momentum. Beneath the softer headline figure, economic fundamentals remain relatively solid. Household spending rebounded after a sluggish start to the year, while businesses maintained a healthy pace of investment, particularly in machinery, equipment and technology. Although trade flows and inventory adjustments weighed on overall growth, private domestic demand continued to provide important support to the economy.

Productivity trends are also moving in a favourable direction. Ongoing capital spending is helping firms improve efficiency and partially offset rising operating and financing costs. Inflation, however, remains a concern. Higher energy prices and the lingering effects of tariffs have kept upward pressure on prices, while recent inflation data suggest limited progress toward the Federal Reserve's target. Against this backdrop, expectations for near-term interest rate cuts have receded, and markets are increasingly considering the possibility that monetary policy could remain restrictive for longer than previously anticipated.

The labour market has shown renewed resilience in recent months. Employment gains strengthened in August, with payrolls rising by 162,000, while the unemployment rate remained stable at 4.1%. Labour force participation also edged higher, reversing part of the decline observed earlier in the year. At the same time, wage growth has continued to moderate, reducing the risk of persistent wage-driven inflation while still supporting consumer spending. Overall, labour market conditions remain healthy, even if they are no longer generating the exceptional gains seen over the past several years. As a result, the U.S. economy appears to be transitioning toward a slower but more balanced expansion. That said, elevated inflation, higher long-term borrowing costs and ongoing trade uncertainties continue to pose risks to the outlook in the months ahead.

Geopolitical tensions are keeping oil markets on edge

Oil prices remain elevated as disruptions to traffic through the Strait of Hormuz continue to restrict one of the world's most important energy trade routes. The escalation of tensions involving Iran, the United States and Israel earlier this year triggered a sharp rise in crude prices, reflecting concerns about the security of global energy supplies. While diplomatic efforts have reduced the risk of a broader regional conflict, the continued limitations on maritime traffic through the strait are keeping a significant geopolitical premium embedded in oil markets.

The supply shock initially reduced the availability of crude exports from the Gulf region and heightened uncertainty around future shipments. OPEC+ has also maintained a cautious approach, signalling that production decisions will remain data dependent and responsive to market developments. This measured stance has contributed to tighter market conditions by tempering expectations of a rapid increase in supply.
However, the underlying balance between supply and demand appears less restrictive than current prices might imply. Output growth from non-OPEC producers, particularly in North America, continues to provide an important cushion against supply disruptions. At the same time, higher energy prices and tighter financial conditions are beginning to dampen global demand growth, limiting the risk of a sustained imbalance in the oil market.

Consequently, current crude prices still seem to be driven more by geopolitical uncertainty than by a fundamental shortage of oil. Unless disruptions intensify or additional supply is removed from the market, elevated prices are likely to persist mainly because of the risk premium attached to ongoing tensions in the region. Volatility is therefore expected to remain high, but a durable move significantly above US$100 per barrel would likely require a more severe deterioration in global supply conditions.

Interest rate differentials are keeping the loonie grounded

The Canadian dollar remains under pressure despite elevated oil prices, illustrating how the forces driving the currency have evolved over time. While the loonie has traditionally benefited from stronger energy markets, its response to higher crude prices has been limited in the current cycle. Instead, exchange rate movements are being driven increasingly by relative growth prospects and financial market conditions in Canada and the United States. In that sense, the Canadian dollar is behaving less like a commodity currency and more like a cyclical one.

A major factor weighing on the loonie is the widening gap between Canadian and U.S. interest rates, particularly in bond markets. While the Bank of Canada has kept its policy rate at 2.25%, U.S. interest rates remain considerably higher, and Treasury yields have continued to trend upward. Investors are demanding greater compensation to hold long-term U.S. government debt, pushing yields higher and making U.S. assets increasingly attractive relative to their Canadian counterparts. As a result, capital continues to flow south of the border, providing ongoing support for the U.S. dollar and limiting the loonie's upside potential.

At the same time, Canada's economic outlook remains more subdued than that of the United States. Growth is expected to remain positive but below potential, business investment is advancing cautiously, and persistent trade uncertainty continues to cloud the outlook. Even though higher oil prices provide some support to Canada's terms of trade, that effect is no longer sufficient to offset the influence of interest rate and growth differentials on the exchange rate.

Looking ahead, the Canadian dollar is likely to remain under downward pressure. A meaningful appreciation would probably require a narrowing of Canada-U.S. yield spreads, lower U.S. bond yields, or stronger Canadian economic momentum. Until then, financial markets are likely to continue favouring U.S. assets, keeping the loonie near the lower end of its recent trading range.

The Bank of Canada is in no rush to move. But...

The Bank of Canada has maintained its policy rate at 2.25% throughout 2026, but the rationale behind that decision has evolved. Earlier in the year, policymakers were primarily focused on weak economic growth and persistent excess capacity. More recently, Governor Macklem's remarks have pointed to growing concern about inflation risks, particularly those stemming from energy markets. While the Bank continues to acknowledge softness in the economy, its emphasis has shifted toward ensuring that recent price pressures do not become more entrenched.

The source of this caution is increasingly clear. Recent inflation data indicate that the pickup in headline inflation has been driven largely by higher energy prices rather than stronger underlying demand. This distinction is important, but it does not eliminate the risk for policymakers. In his latest comments and during the subsequent question-and-answer period, Governor Macklem appeared notably more concerned about the potential spillover effects of sustained energy cost increases. Higher fuel and transportation costs could gradually feed into a broader range of goods and services, slowing the return of inflation toward the Bank's 2% target.

At the same time, economic conditions remain mixed. Growth is modest, labour market conditions have softened compared with previous years, and excess capacity still appears to be present in parts of the economy. Under normal circumstances, such conditions could justify additional monetary easing. However, with inflation risks becoming more prominent, the Bank faces a difficult balancing act between supporting economic activity and preserving price stability.

As a result, the current pause is increasingly reflecting caution rather than indecision. The Bank has already reduced its policy rate by 275 basis points since the peak of the tightening cycle in June 2024, providing meaningful relief to households and businesses. Yet some of that easing has been offset by higher long-term bond yields and wider credit spreads, which have pushed borrowing costs modestly higher in recent months. Consequently, policymakers appear comfortable remaining on the sidelines for now, waiting for clearer evidence on whether weakening growth or persistent inflation will ultimately prove the greater challenge for the Canadian economy.

Higher borrowing costs are resurfacing as a headwind

Canada's housing market remains soft despite lower policy rates. According to CREA, home sales rose for a fourth consecutive month in July, but activity remains below historical norms and price gains have been modest, with the MLS Home Price Index still lower than a year ago.

A growing challenge comes from the bond market. While the Bank of Canada has kept its policy rate at 2.25%, longer-term bond yields have moved higher. Because fixed mortgage rates are tied more closely to bond yields than to the overnight rate, borrowing costs have stopped falling and, in some cases, have edged higher again.

SMEs were gradually adapting to uncertainty, but confidence may be deteriorating again

Business confidence had been recovering from the lows reached earlier in 2026, suggesting that many entrepreneurs were gradually adapting to a more uncertain environment. Sentiment remained below levels typically associated with strong economic expansion, but it became more stable over the summer as trade negotiations progressed and a Canada-U.S. agreement appeared increasingly within reach by late August. 

That stabilization always looked fragile. Higher energy prices, renewed geopolitical tensions and rising long-term interest rates are adding fresh pressure to an environment that was already weighing on business decisions. As a result, many SMEs remain hesitant to accelerate hiring or undertake major investment projects, despite signs of improvement in economic activity.

In short, Canadian SMEs seemed to be learning to live with uncertainty through the summer, but the latest developments are likely to reverse part of those gains. Rather than improving further, business confidence now appears vulnerable to another period of weakness as economic and geopolitical risks re-emerge.