Which country faces the greater inflation threat?
Canada faces a lower risk of a sustained inflation surge than the United States in the event of a prolonged oil price shock, according to an analysis published by CIBC Capital Markets economists.
The report challenges growing market expectations that the Bank of Canada will raise interest rates more aggressively than the US Federal Reserve before the end of 2026.
Rising oil prices, alongside supply disruptions linked to the closure of the Strait of Hormuz, have prompted markets to price in roughly two 25-basis-point rate increases in Canada before year-end, replacing earlier expectations of a Fed rate cut with the possibility of a rate hike.
The CIBC economists argue that this market pricing does not reflect the underlying economic conditions in either country.
The two central banks largely moved in step from the start of the pandemic through the end of 2022. The Fed subsequently tightened policy more aggressively, and when easing began, the Bank of Canada moved earlier and cut rates more deeply than its US counterpart.
Output gap and labour markets
A key distinction between the two economies lies in their output gaps – a measure of how far an economy is operating above or below its non-inflationary potential.
Canada’s output gap has moved into negative territory, signalling growing economic slack, while the US economy has continued to expand above trend, with the Congressional Budget Office pointing to overheating risks.
The softer Canadian labour market has also slowed growth in worker compensation to roughly 2% over the past four quarters, compared with about 4% in the United States. The economists say this translates into weaker household purchasing power in Canada, reducing businesses’ ability to pass higher costs on to consumers.
Real per-capita household incomes in Canada were already declining before the recent increase in gasoline prices, the report notes.
Inflation trends
Core inflation, as measured by the Bank of Canada’s preferred indicators, came within reach of the central bank’s 2% target in 2024 and reached that mark last month. In the United States, the core personal consumption expenditures price index stalled just below 3% in 2024 and showed little further deceleration.
Long-term inflation expectations also differ. Canadian household surveys, while slightly below comparable US measures, remain well below their pre-pandemic average. By contrast, the University of Michigan’s US survey is running above levels seen during the previous expansion.
Outlook
The CIBC economists forecast both central banks will hold rates steady for an extended period, with a conditional quarter-point Fed rate cut pencilled in for December if the conflict affecting the Strait of Hormuz ends early.
They say the Bank of Canada’s recent signals suggest it will not raise rates this year if oil-price pressures ease in the second half of 2026. Should crude prices remain elevated through year-end, the report argues that the United States would face a greater risk of a broader inflationary spiral than Canada, making it unlikely that the Bank of Canada would raise rates before, or more aggressively than, the Fed.
Looking further ahead, the economists say the Bank of Canada could gradually lift rates to 2.75% by the end of 2027, but only if trade conditions improve and unemployment declines.
