How will the commodity price surge affect Canada?
As if there weren’t enough uncertainties to navigate through, the world economy now has to deal with a new war in the Middle East. The resulting jump in commodity prices, if sustained, is largely positive for Canada, although there are offsetting factors which should not be discounted. We unpack all of that in this edition of the Economic and Financial Market Update and explain the implications for interest rates and the Canadian dollar.
Underperforming economy
The GDP numbers are in for 2025, and the damage from America’s trade war is evident. Canada’s economy grew just 1.7% last year, the worst performance since the 2020 pandemic recession, as export volumes fell on an annual basis for the first time in five years. That also means Canada underperformed the U.S. for a third consecutive year, with last year’s growth gap between the two countries at about half a percentage point (Figure 1).
Figure 1: Canada underperformed the U.S. again last year
Sources: Statistics Canada, U.S. Bureau of Economic Analysis, FCC Economics
Domestic demand held up better than trade last year, as government and consumption spending offset weakness in housing and business investment, the latter two hammered by low business confidence. One positive development, however, was the expansion of consumption spending despite the worst labour market since the 2020 recession (and the resulting weak growth of real disposable incomes). But that was only possible because consumers dipped into their savings to maintain their lifestyles, as evidenced by a slumping household savings rate, which now leaves Canadians with little room to absorb any future shock.
With no end in sight to America’s trade war (see Box 1 at the end of the report), look for trade and business investment to act as a drag on Canada’s economy again in 2026. The major difference with last year though, is that the offset provided by government and consumption spending might not be as significant this time. While the federal government has laid out its plans for ambitious public projects, related disbursements are more likely than not to take place after 2026. More pertinent to this year is Ottawa’s plan to put public finances on a more sustainable footing (meaning more caution with regards to public expenditures), while consumers are likely to face intensifying headwinds e.g. a softening labour market in sync with slower economic growth, slowing population growth, and a growing debt burden.
Commodity price surge positive for Canada, but watch out for side-effects
Not all is bleak for the economy though. One recent development that offers opportunities for Canada is the jump in commodity prices stemming from the new U.S. war in the Middle East. Heightened security risks in the Strait of Hormuz are now restricting supply of oil and gas from this energy-rich region, pushing up commodity prices to multi-year highs (Figure 2).
Figure 2: Commodity prices jump to highest since 2022 due to new war in the Middle East
Sources: Bank of Canada, FCC Economics
Given its high historic correlation with commodity prices, nominal GDP (which matters for government revenues) is likely to also perk up (Figure 3). GDP would likely benefit from improved “terms of trade” (i.e., the ratio of export prices to import prices) and possibly from increased energy investment and output.
If the increase in commodity prices is sustained, the federal government, but also provincial governments (particularly those of resource-rich provinces like Alberta, Saskatchewan, and Newfoundland & Labrador) will see higher revenues, leading to smaller budget deficits than originally planned. That does not necessarily mean the federal and provincial governments will increase expenditures as a result, but there is certainly potential for a spending-related boost to GDP growth if the uptick in commodity prices is sustained.
That said, higher commodity prices also present challenges for the economy. We recently explained how surging fertilizer prices, amid the Middle East crisis, are weighing on Canada’s agricultural sector. Soaring commodity prices can also push up inflation (e.g. higher prices for gasoline and other fuels), further eroding purchasing power of already vulnerable consumers.
Figure 3: Nominal GDP, CPI, and the Canadian dollar positively correlated with commodity prices
*Correlation between year-over-year growth of BoC commodity price index and year-over-year growth of GDP, C$, and the consumer price index, calculated using quarterly data over 1981-2025
Sources: Statistics Canada, Bank of Canada, FCC Economics
How does the Bank of Canada respond to soaring commodity prices?
Another channel through which a commodity price shock could restrain the economy is by keeping monetary policy tighter than would otherwise be the case. As mentioned above, they do tend to raise overall inflation, which matters to the Bank of Canada.
There’s little the central bank can do to address supply shocks, but it can certainly influence demand. One thing the Bank of Canada fears more than inflation itself is long-term inflation expectations. Those expectations have been well anchored over the past several decades, which helped keep inflation largely under control. But if the commodity price surge is sustained long enough as to force businesses to raise their prices (especially in light of Canada’s chronically weak productivity growth) and workers to demand compensation for the erosion of their standards of living, that could potentially trigger a wage-price spiral. This is why the Bank of Canada will be watching closely its quarterly surveys of consumers and businesses for clues about long term inflation expectations. If those expectations increase materially, the Bank of Canada may be forced to raise interest rates pre-emptively to prevent core inflation from taking off.
In light of the commodity price shock, we have raised our 2026 forecast slightly for headline inflation. That said, we remain comfortable with our call for GDP growth to slow to around 1% in 2026, which is below the estimated “potential GDP” growth, meaning that core inflation is likely to remain under wraps even if there are periods of volatility on the headline rate. As such, barring a de-anchoring of inflation expectations, the Bank of Canada should remain in pause mode for the next several months.
That’s not to say long term interest rates will also remain stable. As we explained in an earlier edition of the Economic and Financial Market Update, Canadian bonds are highly correlated to U.S. bonds. Uncertainties about U.S. inflation tend to encourage bond investors to demand a larger “term premium” to compensate them for higher risks (Figure 4), pushing up yields on U.S. Treasuries (and therefore Canadian bonds) as a result. The recent surge in commodity prices arguably enhances those uncertainties and therefore could keep long bond yields elevated for longer. If that’s the case, look for Canada’s housing and consumption spending to be somewhat constrained.
Figure 4: High U.S. inflation tends to push up term premium and, therefore, long bond yields
Sources: Federal Reserve Bank of New York, FCC Economics
How high can the loonie fly?
Another way the commodity price surge could restrain the economy is through the exchange rate. Historically, the Canadian dollar appreciated in synch with rising commodity prices (see Figure 3 again), reducing competitiveness of our exporters as a result. The loonie has indeed appreciated against the U.S. dollar since the war started at the end of February.
It’s worth pointing out, however, that the Canadian dollar’s responsiveness to commodity prices has diminished since 2022, coinciding with a widening of Canada’s yield disadvantage with the U.S. - recall the Bank of Canada’s policy rate remains well below that of the U.S. Federal Reserve, which incentivizes the flow of capital towards America. Over the last four years, the loonie has remained below levels that would be expected given movements in the Western Canada Select oil price (Figure 5).
Considering the above-mentioned low responsiveness and our belief that the yield disadvantage won’t disappear anytime soon, we expect the Canadian dollar to trade in the 72-74 U.S. cent range for most of 2026, although we acknowledge currency volatility could temporarily take the loonie outside of that range.
Figure 5: Canadian dollar’s responsiveness to oil prices has diminished in the last four years
Sources: Statistics Canada, FCC Economics
Bottom line
The commodity price increase, if sustained, presents a mixed bag for Canada. On the plus side, government revenues would get a boost from the resulting increase in nominal GDP, and business investment could potentially bounce back in the resources sector. However, inflation could also make an unwelcome return and, as a result, keep interest rates higher than would otherwise be the case, restraining housing, consumption spending, and therefore real GDP in the process.
Summary of forecasts of key economic variables
Sources: Bloomberg, FCC Economics
Box 1 - IEEPA tariffs replaced by “Section 122” tariffs: What does this mean for Canada?
On February 20th, the U.S. Supreme Court ruled against the “reciprocal” tariffs imposed by the White House under the International Emergency Economic Powers Act (IEEPA). In response, the Trump Administration replaced the IEEPA tariffs with a 10% tariff on trade partners (and threatening to increase that rate to 15%) using Section 122 of the Trade Act of 1974 which allows such measure to be imposed for 150 days, at the end of which Congressional approval will be required for an extension.
So, how does all of that affect Canada? Well, it’s complicated.
First, the easy part. The majority of Canada’s exports are entering the U.S. tariff-free thanks to CUSMA and won’t be immediately affected by the changes. Also unaffected by the changes are industries hurt by tariffs imposed under Section 232 of the Trade Expansion Act of 1962 (e.g., sectoral tariffs on aluminum, steel, copper, lumber) which were not covered by the U.S. Supreme Court ruling. The only folks who will notice a significant difference are the small share of exporters who are not CUSMA-compliant because they will see a drop in the tariff rate from 35% to 10%. So, at first glance, the changes to U.S. trade policy seem to be overall positive for Canada.
But note that other countries exporting to the U.S. i.e., Canada’s competitors, will also see their tariff rates drop to 10%. Most of those countries, aside of Mexico, do not have a CUSMA-type trade agreement with the U.S. That means the majority of their exports (unlike the small share of exports for Canada and Mexico), which were previously entering the U.S. with a 35% tariff, will now do so with only a 10% tariff. In other words, the changes favour competitors of Canada and Mexico in a relative sense.
Another piece of bad news for Canada and Mexico is that Section 122 tariffs may not be extended by Congress when the 150 days are up (which would take us to around July 24th). If that’s the case, and the White House cannot find another obscure law to support a new tariff to replace Section 122 tariffs, exports worldwide would be entering the U.S. at a low tariff rate, effectively reducing the CUSMA advantage. That is why The Budget Lab at Yale University is expecting the GDP hit to Canada and Mexico to be even more brutal if Section 122 tariffs expire come July (Figure 6). Simply put, America’s trade war while devastating to Canada, is even more so if it does not extend to our competitors.
Figure 6: Long-run change in real GDP (in percentage points) due to Section 122 tariffs
Source: The Budget Lab at Yale University
Krishen Rangasamy
Manager, Economics, Principal Economist
Krishen is the Manager, Economics and Principal Economist at FCC. His insights and leadership help guide research on topics related to macroeconomics and agriculture, which FCC and external clients use to support strategy and monitor risk.
Prior to joining FCC in 2023, Krishen spent over fifteen years as a macroeconomic specialist on Bay Street, including at two major Canadian banks, where he advised trading desks and helped lead economic research and forecasting. He also regularly appeared on leading business TV channels and written media with his insightful commentaries on financial markets. Before going into investment banking, Krishen worked as an analyst in the energy industry in Western Canada. Krishen received his master of arts degree in economics from Simon Fraser University.