Appendix: Potential output and the nominal neutral rate of interest

Canada’s potential output growth is anticipated to slow due to declining population growth and the ongoing trade conflict. The range for Canada’s neutral interest rate lies between 2.25% and 3.25%.

Canadian potential output

Uncertainty about US trade policy means that the outlook for potential output growth is less clear than usual. This Report provides two estimates that correspond with the two outlook scenarios (see Assumptions for the outlook scenarios and Table A-1).

In both scenarios, the sharp decline in population growth—reflecting the federal government’s 2025–27 Immigration Levels Plan—plays a significant role in reducing potential output growth. The trade conflict also contributes to this decline. In Scenario 1, weak business investment modestly lowers potential output growth. In Scenario 2, potential output growth decreases further due to long-term efficiency losses from reduced trade and a less efficient allocation of resources.1

Growth of Canadian potential output slows

Potential output is the maximum level of output that can be supported over the long term while keeping inflation at the 2% target. It is influenced by structural factors, such as demographics, education, technology and innovation. Domestic and foreign trade policies also influence potential output through their impact on how resources are allocated across industries, which matters for total productivity over the long term.

In both scenarios, potential output growth slows significantly due to declining growth of trend labour input (TLI) (Chart A-1). This is mainly caused by slower population growth. Population growth moderates from 3.3% in 2024 to 0.5% on average in 2026 and 2027 due to lower immigration targets and measures to reduce the flow of non-permanent residents. It then picks up modestly to 0.9% in 2028.

Scenario 1

Canadian potential output growth declines from 2.9% in 2024 to an average of 1.6% in 2025 through 2028 (Chart A-1 and Table A-2). This growth dynamic is broadly similar to that in the April 2024 Report.

Growth in trend labour productivity (TLP) increases from -0.5% in 2024 to an average of 1.2% over 2025 to 2028. This rise is supported by an improvement in trend total factor productivity (TFP) growth and an increase in the ratio of capital to labour due to the slowdown in population growth. These factors more than offset the negative impact on business investment from trade-related uncertainty. Relative to the April 2024 Report, potential output growth is modestly lower.

Scenario 2

Potential output growth in Canada slows more abruptly than in Scenario 1, falling to an average of 0.9% in 2025 through 2027 before recovering to 1.6% in 2028 (Chart A-1 and Table A-2). Despite the gradual rebound in potential output growth, the level of potential output is permanently lower due to the tariffs.

TLP growth rises more gradually than in Scenario 1, increasing from -0.5% in 2024 to an average of:

• 0.4% in 2025 and 2026
• 0.9% in 2027 and 2028

Two factors are behind this:

• investment is even weaker because foreign demand is permanently lower
• broad-based tariffs lead to major structural changes and weaken growth in trend TFP

Over the long term, US tariffs lead to reduced international trade and a shift in production away from sectors where Canada has a comparative advantage, resulting in efficiency losses. In the near term, tariffs have an even more pronounced impact on productivity because businesses affected by reduced trade scale back on their production. This in turn leads them to repurpose their machinery and equipment to less efficient uses and to lay off workers who would need to re-skill. 

Risks

Estimates of potential output are highly uncertain because some of its components are unobservable and difficult to project. The outlook for potential output in each scenario is subject to both upside and downside risks. These include:

• a higher or lower future pace of immigration to Canada
• stronger TLP growth resulting from the widespread adoption of artificial intelligence (AI)2
• structural reforms, such as reductions in interprovincial trade barriers

Scenario 1

Growth in global potential output eases from about 3.1% in 2024 to 2.9% in 2027. The aging global population is the main reason for this decline. Trade policy uncertainty also reduces the level of global potential output by a modest 0.1% by 2027. However, AI-related capital investments and TFP growth support potential output in many economies. The United States experiences the largest gains, followed by China, the euro area and Japan. Overall, Scenario 1 is broadly similar to the outlook for global potential output growth presented in the April 2024 Report:

• Growth in potential output in the United States slows. An aging population and tighter immigration policies weigh on TLI growth. These effects are partially offset by AI-related capital spending and efficiency gains. The outlook is revised up compared with the April 2024 Report as a result.
• In China, potential output growth slows because business investment moderates from its current elevated pace. This impact is partially offset by a higher retirement age and AI adoption. The outlook for growth has been revised up from the April 2024 Report largely due to these factors.
• Potential output growth in the euro area is modest, at about 1%. The lingering effects of Russia’s invasion of Ukraine and competitiveness challenges in the euro area’s manufacturing sector lead to a slower pace of business investment, which weighs on growth. This is partially offset by increased fiscal investment in defence and infrastructure.

Scenario 2

A severe US-driven trade conflict slows global potential output growth to around 2.8% by 2026. The level of potential output is about 0.5% lower by 2027 than it is in Scenario 1. Severe tariffs affect all regions, significantly reducing productivity by displacing resource allocation away from more productive uses. The cyclical slowdown in investment results in a lower capital stock in all regions relative to Scenario 1. The impacts are most significant for the United States and its major trading partners:

• US potential output growth slows to 1.7% by 2026 and remains below 2% in 2027. Reduced labour productivity results in potential output being 1% weaker than in Scenario 1 by 2027 (due to less capital deepening and less TFP growth).
• Other regions also see lower potential output in this scenario, although the impact is less severe.

Risks

The outlook for potential output in each scenario is subject to both upside and downside risks. These include:

• The US administration’s wide range of policy announcements (from cuts to corporate and personal income taxes to deregulation and tariffs) point to both upside and downside risks.
• Countries may adopt a more expansionary fiscal stance to help offset the impact of the tariffs. If spending is directed toward measures that improve productivity and investment, potential output could rise.

Neutral rate

Under both scenarios, the Canadian neutral rate lies between 2.25% and 3.25%, unchanged from the April 2024 assessment.3

Because Canada is a small open economy, its neutral rate is linked to the global neutral rate, which is proxied by that of the United States. The US neutral rate is within a range of between 2.25% and 3.25% in both scenarios, unchanged from the April 2024 Report:

• In Scenario 1, tighter immigration policy and rising macroeconomic uncertainty offset the impact of stronger productivity growth.
• In Scenario 2, potential output growth is weaker than in Scenario 1, and the ratio of government debt to gross domestic product is smaller.4 Both factors weigh on the US neutral rate but are not large enough to move the range.

With the unchanged US neutral rate and offsetting domestic factors, the Canadian neutral rate remains the same in both scenarios. Slowing growth of long-term TLI is partially offset in both scenarios by a pick-up in growth of long-term TLP. Even in Scenario 2, potential output growth in Canada largely rebounds after about three years as the economy adjusts to reduced trade. Although efficiency losses lead to a permanently lower level of TLP, the effects on its long-term growth rate are limited.

Risks

These estimates are subject to some important risks.

• Structural changes, such as the impact of further isolation of the US economy, could affect the link between the US and Canadian neutral rates. If Canadian borrowers become less willing or find it harder to access funding in US capital markets, they would need to turn to other markets. Since the US capital market is the world’s largest and most liquid, this could lead to higher interest rates for Canadian borrowers. This would cause the Canadian neutral rate to rise.
• Low confidence and heightened consumption growth risk could lead to an increase in long-term precautionary savings. This would exert downward pressure on the Canadian neutral rate.

Similar to potential output, the neutral rate is unobservable and can be inferred only by considering the evolution of its observed factors. Because of this, considerable inherent uncertainty exists for the neutral rate estimate. This reflects, in particular, uncertainty around the factors behind it, such as potential output and the balance between global savings and investment.

Endnotes