The war in the Middle East—Transmission channels and risks to inflation

The war in the Middle East is affecting the Canadian economy in several ways. Inflation will be higher in the near term, but the magnitude and persistence of the increase is uncertain. The net impact on growth is expected to be small.

The war in the Middle East is affecting the Canadian economy primarily through higher energy prices. As a net exporter of energy, Canada is expected to fare much better than countries that are heavily dependent on imported energy. The extent of the benefits to Canada will depend on how long energy prices remain elevated. In the base-case projection, prices decline fairly quickly from recent highs, so the impact on gross domestic product (GDP) is small. Persistently high energy prices would tilt the balance toward somewhat stronger economic activity in Canada. Higher prices for energy and agricultural products are expected to raise consumer price index (CPI) inflation in the near term and increase the risk that inflation persists above target.

Canada’s economy is affected through several transmission channels

Real GDP

As a net energy exporter, Canada has historically seen stronger economic growth associated with elevated energy prices, particularly when they have risen for an extended period due to robust global demand. In such episodes, improved terms of trade have raised profits in the energy sector, supporting higher consumption, business investment and government revenues. The Canadian dollar has also tended to appreciate.

However, in the base‑case projection, the positive impact on growth is expected to be small. The recent increase in oil prices reflects a disruption in the global supply of oil rather than stronger aggregate demand, so non‑energy exports do not increase. In addition, greater foreign ownership of shares in oil and gas companies in Canada means that less of the additional profits now accrue domestically. As a result, the positive impacts on employment, consumption and investment are likely to be more muted than in the past.

Higher prices for energy and food will reduce households’ purchasing power, and some consumers will have to cut back on spending in other areas.

For the energy sector, the assumed temporary nature of the increase in oil prices and a shift toward higher dividend payments are expected to limit the near-term boost to investment. Improvements to capital efficiency also allow businesses to expand output with less additional investment than in the past. Several factors will likely limit the appreciation of the Canadian dollar, including:

• expectations that the oil price increase will be short-lived
• larger dividend outflows
• a more muted increase to foreign direct investment
• safe-haven effects associated with the war

Overall, the boost to activity in the energy sector and the drag on household spending from higher consumer prices largely offset each other.

Inflation

In the base‑case projection, year‑over‑year CPI inflation temporarily rises to 2.6% in the second quarter and then declines over the remainder of 2026 as oil prices are assumed to moderate. The near‑term increase primarily reflects higher oil prices pushing up the costs of gasoline, other transportation and food. Core inflation in 2027 is also modestly higher.

An illustrative scenario with persistently higher energy prices

Considerable uncertainty still exists about the duration of the conflict and its impact on energy prices and global growth. In particular, the base‑case outlook for inflation in the second half of 2026 and in 2027 is highly conditional on the assumption that oil prices begin to normalize relatively quickly. The impacts on production and transportation costs and on economic activity in Canada are also highly uncertain and will depend on how business pricing behaviour and household spending respond.

If the conflict intensifies or proves more prolonged than anticipated, CPI inflation could rise higher and remain elevated for longer, despite weaker global growth and lower demand for Canada’s non‑energy exports. Such a situation would increase the likelihood of significant cost pressures coming from shipping disruptions, higher freight and insurance costs, and shortages of critical imported intermediate inputs such as semiconductors. Pass‑through of cost pressures into a broader set of goods and services prices could also increase. In this situation, safe‑haven flows would likely limit the appreciation of the Canadian dollar against the US dollar, reducing the offset to rising cost pressures. This implies that the base-case assumption for the Can$/US$ exchange rate is carried into the illustrative scenario.

To roughly illustrate the responses of output and inflation to such a situation, this section presents a scenario in which oil prices are at US$100 per barrel for the entire projection horizon and beyond. With a persistent rise in oil prices, government revenues are higher than in the base‑case projection. Half of the additional government revenue associated with royalties from the energy sector and taxes is assumed to be transferred back to Canadian households. The pass‑through of costs to prices is larger and occurs over a longer period than in the base-case projection.

In this scenario, Canadian GDP growth is little changed in the near term compared with the base-case projection because it takes time for higher energy prices to translate into increased activity (Chart 24). In 2027 and 2028, larger government transfers to households, combined with stronger business investment and energy exports, push GDP growth slightly above the level in the base‑case projection.

In the first year of the scenario, inflation pressures are higher than in the base-case projection mostly because of the direct impact of higher oil prices on gasoline and food prices. Inflation peaks at 3.1% in the first quarter of 2027 and is close to 3% for more than a year (Chart 25). This is both higher and substantially more persistent than in the base‑case projection. Cost pressures gradually broaden, reflecting increased domestic distribution costs and higher prices for imported intermediate goods. As a result, year‑over‑year inflation remains elevated well beyond the first year of the scenario, reflecting persistently greater inflation pressures outside of food and energy. Importantly, long‑term inflation expectations in Canada remain well anchored near 2%. Nevertheless, tighter monetary policy is required, resulting in consecutive increases to the policy interest rate. Higher interest rates significantly limit the increase to GDP and bring inflation back to the 2% target.