Monthly Forecast Update

Highlights:

Issue in focus:

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Forecast changes:

A second contraction in real GDP in Q1 in Canada has not led us to revise our growth outlook. Per-capita growth continued to expand (see Issue in Focus below), and the unemployment rate (incorporating the positive labour market data in May) tracks in line with our previous quarterly base case forecasts.

For us and the BoC, the unemployment rate is not only a measure of labour market health, but also an important gauge of the economy’s output gap. In May, it remains elevated at 6.6%, which suggests moderate slack in the economy, but not in significant excess to our previous expectations.

In the forecast update this month, we mostly passed through the downside GDP surprise to our estimates of potential GDP growth, while keeping the size of the output gap unchanged—still moderately negative, but similar and consistent with the -0.5% to -1.5% range estimated by the BoC in April.

CUSMA exemptions yet again maintained in new Section 301 investigations

CUSMA exemptions were again preserved, amid recent U.S. Section 301 investigations for new measures to replace existing Section 122 measures at the end of July. The Annex also included a long list of separately exempted products adding up to about half of total U.S. goods imports in 2025 (virtually identical to exempted products as a share of total imports from current Section 122 tariffs).

These developments are broadly consistent with our assumption that U.S. tariffs will continue to moderate. In May, the U.S. Department of the Treasury reported US$23.5 billion of custom duties—lowest in a year although still well above the average US$8.2 billion collected monthly in 2024.

Importantly, as the pre-scheduled CUSMA review is set to get underway, a non-renewal outcome does not mean automatic expiration of the agreement, but rather that negotiations will likely follow all while the agreement remains in place until 2036. We continue to assume CUSMA agreement and related exemptions will remain status quo, through what is likely to be a lengthy review/negotiation period.

BoC and Fed still on hold but risks to steady path are rising

In Canada, persistent excess slack after the economy grew consecutively below its potential is weighing on core inflation trends. In the U.S., the unemployment rate is persisting at decade-low levels, suggesting excess demand in the economy consistent with sticky core inflation readings above the Fed’s 2% target.

Current central bank key policy rates—BoC at the lower end of the neutral range and Fed at the upper—already reflects this divergence. Risks, however, are the interest rate gap between the two countries could further widen if recent data trends persist, but we’re not there yet.

For now, we continue to expect holds from both central banks before the BoC begins to raise rates in the first half of 2027. The runway to rate hikes could lengthen if the Canadian economy takes meaningfully longer to improve than our base case forecast. And the Fed could hike rates if sticky core inflation in the U.S. starts to accelerate, while the labour market holds onto strength.

Summary of changes we made to our forecasts in June:

• Canadian growth and labour market forecasts are unchanged: We assume the Q1 GDP contraction was driven by structural weakness (soft productivity growth and labour input as the population declines), and passed it on to softer potential GDP growth. Real GDP is expected to expand 0.6% (down from 1.2%) in 2026 before accelerating to 1.5% (unchanged) in 2027.

• We lowered our Q2 and Q3 U.S. unemployment rate projections marginally after consecutive labour market upsides when job gains came in well above our estimates of break-even employment growth. U.S. GDP forecasts remain the same –we still expect growth to pick up slightly over the remainder of 2026 to leave the annual increase at 2% (down slightly from 2.1% due to Q1-26 revisions).

• BoC and Fed forecasts are unchanged. We expect no moves this year from the BoC and four 25 basis point rate hikes in 2027. The hikes are contingent on the economy improving as expected. The Fed is expected to remain on hold throughout the forecast horizon.

• BoC
• Fed
• BoE
• ECB
• RBA

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2.25%

0 bps in Jun/26

0 bps

Jul/26

The Bank of Canada, as expected, held the overnight rate at 2.25% in June. Governor Macklem described the economy to be in a similar place as in April and reiterated that the current stance of monetary policy remains appropriate to balance the growth-inflation trade-off. We continue to expect the BoC will remain on hold in 2026 before hiking moderately against an improving economic backdrop in 2027.

3.5-3.75%

0 bps in Jun/26

0 bps

Jul/26

The Fed held the Fed Funds rate steady in April as expected, but amid growing dissent. Most FOMC members still view policy as slightly restrictive, but the committee did transition from a majority cutting bias to a narrower one. We still expect the Fed to hold rates steady through 2027. Against that base case, we see risks of a hike outweigh those of a cut given below-neutral real Fed Funds rates, and robust labour reports.

3.75%

0 bps in Apr/26

0 bps

Jun/26

The Bank of England’s Monetary Policy Committee voted 8-1 in favour of holding Bank Rate at 3.75% in April but retained a hiking bias. The MPC softened its language from March in terms of inflationary risks from the conflict in the Middle East. Data since the April meeting (labour market, CPI, PMIs) have been softer-than-expected, putting our call for one more rate hike in July this year before the BoE goes on hold at risk.

2.0%

0 bps in Apr/26

+25 bps

Jun/26

The European Central Bank held rates unchanged at 2% in April while introducing a hiking bias. President Christine Lagarde said directionally the ECB knows where it’s heading, and that despite the hold in April, potential rate hikes were discussed in depth. We expect three 25 bps hikes this year in June, September and December, to bring the policy rate to a terminal of 2.75%.

4.35%

+25 bps in May/26

 +25 bps

Jun/26

The Reserve Bank of Australia hiked rates by 25 bps in May in an 8-1 vote. Since the start of 2026, the RBA has lifted rates by 75 bps that according to the statement, leaves monetary policy “well placed to respond to developments.” Softer-than-expected April CPI data leaves a June hike unlikely. We now expect building inflation pressures over the summer to drive one other 25-bps hike in August for the cash rate to reach 4.6%.

Issue in focus:

Canada’s per-capita economy still recovering

Canada’s consecutive GDP contractions in recent quarters sparked concerns about the state of the economy. Part of the weakness, however, reflected sharp swings in population growth that continue to disrupt traditional interpretations of data.

In examining per-capita data relative to previous recessions, we found the Canadian economy looks more consistent with an early-stage recovery than a sharp, synchronized contraction typical of past recessions.

That said, structural challenges, including weak business investment, a multi-year real estate slowdown, and rising living costs—particularly for lower-income Canadians—all persist.

Risks around the conflict in the Middle East and U.S.-Canadian trade tensions also remain heightened, clouding over the outlook for a per-capita economy that’s proven relatively resilient so far. Read more

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About the author:

Claire Fan is a senior economist at RBC. She focuses on macroeconomic analysis and is responsible for projecting key indicators including GDP, employment and inflation for Canada and the US.

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