NextFin News - Bank of Canada Deputy Governor Toni Gravelle has laid bare the policy bind gripping the central bank, describing a "very complex situation" in which the rate-setting Governing Council is locked in "very vigorous, deep debates" over how to weigh the growth-damaging effects of the escalating trade war against the inflationary punch of war-driven energy prices. The comments, made Tuesday at the Canadian Finance Conference in New York, underscore that the September rate hold was less a resolution than a truce between two supply shocks pulling monetary policy in opposite directions.
A senior Bank of Canada official said the rate-setting body is in a "dilemma" over how to balance the trade-war drag against the inflation effects of high energy prices. Two weeks earlier, the Bank held its overnight rate target at 2.25% and published deliberations showing Governing Council members had "agreed that the risks to inflation from persistently high energy prices had increased," while also warning that new US tariffs on roughly 5% of Canadian goods exports would weigh on confidence, spending and investment. The next decision, on October 28, will come with a fresh Monetary Policy Report — the first full forecast since the tariff re-escalation.
The Two Shocks Pulling Policy in Opposite Directions
Gravelle's framing is unusually candid for a central banker. With the economy still in excess supply and the unemployment rate around 6.5%, weaker growth from the trade conflict could keep inflationary pressures contained. But if higher energy prices spill over into other components of the consumer-price index, members agreed it "could require a monetary policy response to prevent broad-based inflation from setting in." The Bank has drawn that threshold for itself: look through energy costs while they stay contained, act if they spread.
The two shocks are not symmetrical in how they hit the economy. Tariffs weaken demand — a channel that, left alone, argues for easier policy. Energy prices lift the price level while leaving households with less to spend elsewhere — a channel that argues for restraint. That asymmetry is what makes the policy call hard, and it is showing up in the data. Statistics Canada reported July GDP was essentially flat, with manufacturing down 0.9% and potash mining falling 6.4%. August consumer-price inflation held at 3.0% year over year, with gasoline inflation alone at 22.8% and the overall energy index up 15.4% — even as the core measures, CPI-trim at 1.9% and CPI-median at 2.0%, stayed close to the 2% target.
Governor Tiff Macklem has been more explicit about the stakes. Speaking in Halifax on September 21, he said that if the new US tariffs remain in place, fourth-quarter growth "could be roughly halved... to below 1%," down from the 1.5% third-quarter pace the Bank had forecast in July. He also noted that with annual inflation at 3%, it could edge higher if oil prices remain near US$100 a barrel. Growth is stalling at the margin even as headline inflation sits at the top of the Bank's 1-to-3% control range.
The tariff episode itself has moved quickly. On August 22, the United States imposed 50% tariffs on roughly 5% of Canadian exports, and Ottawa announced counter-tariffs of its own. Before trade talks fell apart earlier in the month, economists and financial markets had widely expected the Bank to stay on the sidelines for the rest of 2026 and into 2027. The re-escalation reset that calculus, turning a settled outlook into an open question.
The Mechanics of a Supply-Shock Bind
The Bank of Canada is not facing one shock but two, and they transmit through different channels. The tariff shock works through trade volumes, business confidence and investment. The energy shock works through the price level and inflation expectations. This is the classic central-bank dilemma of an oil-driven supply shock, updated for a small open economy that is also a net energy exporter.
Higher oil prices raise export revenues and national income, which supports GDP on one side of the ledger. But higher gasoline and diesel prices hit consumers directly, raise costs for businesses, and — if they persist — risk becoming embedded in wage and price setting. The Bank's own deliberations noted that refinery margins remained unusually high owing to disruptions to both Middle Eastern and Russian refinery capacity, with no indication the conflict was nearing resolution or that shipments through the Strait of Hormuz were normalizing.
The transmission mechanism that matters most is second-round pass-through. As long as higher energy costs stay contained in the energy component of the CPI, the Bank can look through them. The moment they feed into core goods, services and wages, the calculus changes — because then the shock is no longer a relative-price adjustment, it is broad-based inflation. That is the threshold the Governing Council has drawn for itself, and it is the line that would force its hand.
There is a third channel that links the two shocks: the currency. A trade war that hits Canadian exports tends to weigh on the loonie, and a weaker currency makes imports more expensive, adding to inflation. Conversely, higher oil prices historically support the Canadian dollar, which dampens imported inflation. The two effects partly offset, which is another reason the net inflation impact is hard to read in real time — and another reason the Bank is waiting rather than reacting.
Cyclical Shocks, a Structural Constraint
Both the trade war and the energy shock are, in origin, cyclical and policy-reversible. A trade deal could remove the tariffs; a resolution to the Middle East conflict could normalize oil prices and refinery margins. Neither is a permanent regime shift in the way that deglobalization or a commodity supercycle would be. Historical experience with past oil shocks also suggests the first-round price spike is often followed by normalization once supply disruptions ease — the Bank's March 2026 deliberations noted that the global economy now uses less oil per unit of output, limiting the pass-through to non-energy prices.
But the constraint they impose on the Bank is more structural in nature. Monetary policy cannot offset tariffs or set global energy prices — Governor Macklem made that boundary explicit in both his September 2 opening statement and his Halifax remarks. The Bank's job is narrower: prevent the shocks from knocking inflation persistently away from the 2% target. That means the Bank is being asked to manage the second-order consequences of shocks it cannot fix, with a blunt instrument that affects the whole economy.
This distinction matters for the policy path. If the shocks are cyclical and self-reversing, the correct response is patience — hold rates steady and wait for the data to show whether the weakness is transitory or whether pass-through is occurring. If, instead, the shocks prove persistent and begin to shift behaviour — firms raising prices preemptively, workers demanding catch-up wages — then patience becomes a policy error. The Bank's "vigorous, deep debates" are, in effect, an argument over which of those two worlds Canada is entering. The September deliberations recorded a "diversity of views" on the amount of slack in the economy, meaning that majority position has not yet fully formed.
The interest-rate level also limits how much the Bank can rely on patience. At 2.25%, the policy rate sits at the lower end of the Bank's estimated 2.25%-to-3.25% neutral range — the level that neither stimulates nor restrains. Yet interest-sensitive areas of the economy, particularly housing, have shown little response, suggesting that if more stimulus is needed, the Bank would have to cut below neutral rather than simply return to it. That narrows the margin for error on the growth side.
The Second-Order Problem: Expectations, Not Just Inflation
The first-order question is mechanical: do tariffs slow growth enough to offset energy-driven inflation? The second-order question is about expectations, and it is the one that keeps central bankers awake. If markets and firms conclude the Bank is behind the curve on inflation, inflation expectations drift up and the cost of bringing inflation back to target rises — potentially requiring a sharper, more recessionary tightening later. If instead markets conclude the Bank is too focused on inflation while growth stalls, rate-cut expectations build, the currency weakens, and imported inflation adds to the problem. The dilemma is therefore self-reinforcing: every signal the Bank sends is read through both lenses at once.
This is why the October 28 Monetary Policy Report matters more than the rate decision itself. With the policy rate at 2.25% — at the lower end of the Bank's estimated 2.25%-to-3.25% neutral range — the Bank has room to move in either direction. The fresh forecasts will reveal which shock the Governing Council now sees as dominant, and whether the internal debate has resolved into a majority position. The updated projections are expected to show growth marked down and inflation marked up: the numerical expression of the dilemma.
There is already evidence that the Bank is managing spillovers on the financial-market side as well. Gravelle used the same New York appearance to say the central bank is regularly increasing the size of its two-week repo operations to reduce upward pressure on CORRA, the Canadian overnight funding rate — a sign that liquidity conditions are being nudged even as the policy rate stays put. It is a small adjustment, but it illustrates how the Bank is fighting on several fronts at once: the policy rate for the inflation outlook, and market operations for the plumbing that transmits it.
The Counter-Thesis: There Is No Real Dilemma
The strongest argument against the dilemma framing is that the two shocks are not equally weighted for policy. Canada entered this episode with the economy in excess supply, the labour market soft and wage growth subdued. In that environment, demand destruction from tariffs should dominate the inflation signal from energy — particularly since Canada is a net energy exporter and higher oil prices bring offsetting income gains. Core inflation near 2% suggests underlying price pressure is contained.
By this logic, the Bank's bias should lean toward easing if growth deteriorates, and the "debate" is more about sequencing and communication than about a genuine policy trade-off. Hold now, cut later if the tariff damage materializes; hike only if pass-through becomes unmistakable. Some economists argue the tariff measures themselves are not enough to sink the economy into recession — it is the uncertainty around the long-term trading relationship that chills investment and hiring. Others, including the C.D. Howe Institute's Monetary Policy Council, have recommended holding at 2.25% for six months before a gradual rise, while major bank forecasts see the first hike coming only in 2027. Interest-rate markets are pricing little chance of a move at the October meeting.
The counter-thesis has real force, but it depends on one assumption: that energy inflation stays contained. That is precisely what the Bank says it can no longer take for granted. With the Strait of Hormuz still constrained and refinery margins elevated, the Governing Council has explicitly flagged that a monetary policy response would be required if pass-through takes hold. The dilemma is real because the threshold for that response is a data point the Bank does not yet have.
What to Watch and Where the Trade Breaks
The base case is that rates stay at 2.25% at the October 28 decision, with the Bank preserving optionality: it can cut if the tariff shock dominates, or hike if energy pass-through accelerates. Before then, the Bank will receive September jobs and inflation data and the latest readings from its quarterly surveys of businesses and consumers — prints that several economists expect to carry more weight for the decision than the flat July GDP figure.
The upside case for rates — a hike — requires evidence that energy inflation is spreading. Watch the Bank's core inflation measures and, more importantly, the MPR's discussion of inflation expectations and wage growth. The specific falsifying signal on this side: core inflation at or above 2.5% for two consecutive months alongside evidence of energy pass-through into non-energy goods and services. That would make the "hold and wait" stance untenable and put a hike on the table.
The downside case — a cut — requires clear evidence that the tariff shock is tipping the economy into contraction: a negative fourth-quarter GDP print or unemployment pushing above 7%. Some economists have suggested that if the slowdown proves more pronounced than expected, a reduction in the policy rate by as much as half a percentage point could come into view. Two consecutive negative GDP quarters would take cuts back into active consideration.
For markets, the asymmetry runs through the Canadian dollar and government bonds. A Bank perceived as behind on inflation is bearish for bonds and supportive of the currency via rate differentials; a Bank perceived as capitulating to growth weakness is the mirror image. The October 28 MPR will be the first clean read on which way the Governing Council's internal debate has broken — and the first real test of whether the "dilemma" Gravelle described has been resolved, or merely postponed.
"It's a very complex situation. We've been having very vigorous, deep debates and trying to understand what's happening."
The Bank of Canada is not choosing between growth and inflation — it is choosing which supply shock to believe, and the answer will not be clear until the data forces its hand.
Explore more exclusive insights at nextfin.ai.
