Bank of Canada turns more ‘two-handed’ as ‘Stag’ vs ‘flation’ risks roughly balanced following Hormuz blockage

The Bank of Canada on Wednesday held its policy interest rate unchanged at 2.25%, which is exactly what the market expected. The focus is now on the central bank’s assessment of the Iran War’s impact on the economy. 

Before the Iran War: A Hint of a Downward Bias

The BoC’s assessment of the Canadian economy in the absence of the Strait of Hormuz blockage was actually hinting at a minor downward bias for the next interest rate move. 

• Fourth-quarter GDP in Q4 was weaker than projected with an expectation of continued weakness in the “near-term.”
• The labor market couldn’t maintain the strong growth seen late last year, as the Bank noted, “[e]mployment gains in the fourth quarter of 2025 were largely reversed in the first two months of 2026.”
• Meanwhile, inflation risks looked relatively contained as “CPI inflation excluding changes in indirect taxes as well as core inflation measures have also come down and are all close to 2%. Food inflation slowed in February but remains elevated.”

The Bank was painting a picture of a weakening economy with cost of living pressures largely absent. In other words, if the central bank needed to move, it’s like to cut rates to boost the real economy.

“With recent data pointing to weaker economic activity and uncertainty elevated, risks to growth look tilted to the downside. At the same time, inflation risks have gone up due to higher energy prices.”

The Current Stance: Looking Through Until Otherwise

The outlook, however, was before the US engaged in the Operation Epic Fury. Energy prices rose rapidly as the oil flow through the Strait of Hormuz stopped due to the war. 

Facing a major inflation risk, the BoC stated that it will employ the standard central bank playbook: looking through the energy volatility. 

“With inflation close to target and the economy in excess supply, the risk that higher energy prices quickly spread to the prices of other goods and services looks contained. But the longer this conflict lasts and the wider it gets, the bigger the risks. Governing Council will look through the war’s immediate impact on inflation but if energy prices stay high, we will not let their effects broaden and become persistent inflation.”

But note that they put a lot of emphasis on the conditional: if energy prices remain elevated for a long time, they will move to curb the inflationary pressures from being persistent and broad-based and to stop long-term inflation expectations from becoming unanchored. 

Given the Hormuz situation, the BoC is now acting as a “two-handed economist.” 

• On the one hand, “if energy prices stay high and we start to see evidence that it’s generalizing and becoming more persistent, we can raise policy rate to cool inflation,” said Governor Tiff Macklem in the post-meeting press conference. 
• “On the other hand, if the energy prices come back down and we see more weakness in the economy, we can lower our policy rate to add more support,” he added. 

Looking Ahead: Unprecedented Uncertainty

The main message Macklem wanted to convey in the press conference was that, the war has introduced a huge amount of uncertainty; and the risks are on top of the existing uncertainties relating to US tariffs and the upcoming renewal of the USMCA trade agreement. Which is why the BoC insists on making decisions one meeting at a time, rather than pre-committing to any moves at the moment. 

He also emphasized that 

1. Because Canada is an oil-exporting country, it can potentially benefit from the high energy prices.
2. This time is different from the Covid era— there is no pent-up demand nor excess savings to provide a huge demand impulse. 
3. Canada is, in the short run, less affected by the energy crisis, compared to other regions like the Europe, so the BoC can afford some time to take a wait-and-see approach.