By Douglas Porter

August 22, 2025

Markets revved back up their enthusiasm around potential interest rate relief from the Federal Reserve in the wake of Jay Powell’s hotly anticipated Jackson Hole sermon. Heading into the event, investors had turned somewhat cautious after last week’s concerning round of U.S. inflation results for July and some earlier guarded remarks by Fed officials.

Meantime, a new front opened up on the assault on Fed board members, with Governor Cook cordially invited to resign by the Administration. Amid all these moving parts, the market is back to looking at a strong chance of a rate cut at the September 17 FOMC meeting, albeit still not a lock—there is, after all, almost a full month of data to go. In what was a meaty speech in Wyoming, arguably the key message was found in these two sentences:

“Our policy rate is now 100 basis points closer to neutral than it was a year ago, and the stability of the unemployment rate and other labor market measures allows us to proceed carefully as we consider changes to our policy stance. Nonetheless, with policy in restrictive territory, the baseline outlook and the shifting balance of risks may warrant adjusting our policy stance.”

The rate cut opening helped the equity market break out of a mini slide, which had seen the S&P 500 dip for five consecutive days, with notable softness in tech. The market’s near-unabated rise since April promptly resumed post-Jackson, taking the index to a new record high. Meantime, the U.S. dollar pulled back in the wake of Powell’s remarks, although it has been quietly firming after a six-month bludgeoning in the first half of the year. It had risen to a three-month high against the Canadian dollar above $1.39 (or below 72 cents(US)) just prior to the speech.

On this week’s economic front, the handful of releases largely confirmed that the U.S. housing market was stabilizing at low levels of activity. While starts and sales both perked up somewhat in July, forward-looking indicators remained soft—permits, mortgage applications, and the NAHB Index. The factory sector sent off mixed signals, with regional Fed surveys dropping in August, but S&P’s Global PMI reporting its best month for manufacturing in three years. But, with Powell acutely focused on the job market, perhaps the most intriguing indicator was the back-up in weekly jobless claims to 235,000. More striking was the further rise in continuing claims, which are now at their highest level since early 2018 (aside from that nastiness in 2020/21).

The mildly dovish words from Wyoming weren’t the only breaking news on Friday morning, as it was reported that Canada would be removing a long list of retaliatory tariffs on U.S. goods.

The mildly dovish words from Wyoming weren’t the only breaking news on Friday morning, as it was reported that Canada would be removing a long list of retaliatory tariffs on U.S. goods. Basically, the only items still facing Canadian tariffs will be metals and some autos (largely mirroring U.S. measures). This followed a day after the first conversation between PM Carney and President Trump in weeks and is an important step. The direct implications for the Canadian economy are that it will: a) take some pressure off specific CPI items (e.g., groceries, sporting equipment), which could help shave core inflation back below 3%, and b) further cut into expected tariff revenues. Recall that the Liberal election platform had been based on annual tariff revenues of $20 billion; we are now looking at a fraction of that amount, introducing yet more pressure on the fiscal outlook.

Our longstanding view has been that the inflation threat from the trade war was a tad overblown, for Canada and for the U.S., albeit for different reasons. For the States, its unrivalled market power means that the Administration is not fully offside for asserting that companies will ultimately eat some of the tariffs. For Canada, the two big drivers of potential trade war inflation have vapourized—the retaliatory tariffs, which weren’t that fierce to begin with, have been further declawed; and, the Canadian dollar is 3%-to-4% stronger than when the trade war first erupted, not weaker, even with its recent sag.

The back-down on Canadian retaliation should thus fully quiet the talk of trade-war led inflation, alongside this week’s tempered CPI reading for July. The latter revealed that the three-month core inflation trend eased to 2.4%, its first trip below 3% since last fall. This opens the door to further rate cuts by the Bank of Canada. While a move in September remains a bit of a long shot—markets peg the odds at about 1 in 3—a move in October is seen as likely, and there could be more to come. We continue to lean to the low side, calling for a total of three cuts by next spring, which would take rates just a touch below the low end of neutral. But given the more benign trade-related inflation risks and a softening job market, we believe that below neutral would ultimately be entirely appropriate.

The major economic indicator on the Canadian calendar next week will be quarterly GDP on Aug 29 (i.e., Friday of a long weekend, the last workday of what most consider to be summer… nice). It’s expected to show about a 1% annualized drop in Q2, as exports were walloped (-25% a.r.) by both a reversal from the Q1 tariff front-running, but also amid all the deep trade uncertainty/chaos in the wake of Liberation Day early in the quarter. But we’ll also be closely watching the monthlies; and specifically, the early estimate for July GDP, to see how Q3 is shaping up. We suspect the economy will flatten out in Q3, just averting a so-called technical recession.

But we would also highlight the quarterly balance of payments, which will be released a day earlier. A significant widening in the current account deficit to more than 2% of GDP (or above $70 billion annualized) from near balance in Q1 will hog the headlines. But keep an eye on the capital side of the BOP. Many have noted the sudden drop in portfolio flows in the first half, which has seen heavy net selling of Canadian equities and a drying up of inflows to fixed-income.

However, the counterpoint has been a dramatic turnabout in foreign direct investment. Following 11 consecutive years of outflows—and sometimes large net outflows—FDI has turned the corner. In the past four quarters (to Q1) there was a net FDI inflow of billion, compared with a billion net outflow in the four quarters to 2024Q1 (Chart 1). This sudden turnabout reflects both a big pick-up in the amount of investment flowing into Canada from abroad (to its best level since pre-GFC days), but also a notable slowdown in Canadian companies investing outside of the country. This positive reversal has kept the Canadian dollar from weakening even further over the past year, even as the current account has swelled and portfolio investment flows have turned heavily outward

Policy Contributing Writer Douglas Porter is Chief Economist for BMO.