Scotiabank Forecast: Inflation Pressures to Keep Central Banks Cautious 

• Our outlook is broadly unchanged from the June forecast, and incoming data have strengthened our confidence in the underlying narrative.

• Canada: Recent data have evolved broadly in line with our expectations and continue to support the view that the economy is moving out of the soft patch seen at the start of the year. Despite the volatile situation in the Middle East, oil prices are lower than in our previous forecast, weighing modestly on the near-term outlook, particularly through business investment and total CPI inflation. However, the weaker Canadian dollar broadly offsets that drag by providing support to exports.

• United States: The story is similar, near-term activity looks slightly stronger than previously expected, partly reflecting weaker import growth. Inflation has continued to surprise to the upside in both headline and core measures, reinforcing the case for caution from the Fed.

Our outlook remains broadly unchanged from our June forecast, reflecting a series of offsetting developments since our last update. Financial markets have remained volatile, oil prices have declined, and the Canadian dollar has weakened. At the same time, incoming Canadian data have largely reinforced the dynamics outlined in our June note, suggesting that the economy is beginning to emerge from its recent soft patch. Inflation risks remain elevated in our view, which should keep the Bank of Canada cautious and ultimately lead to a gradual normalization of policy rates beginning toward the end of this year (chart 1). In the United States, economic activity continues to display resilience despite the expected moderation in household demand as hiring remains modest and real wage growth stalls. Meanwhile, inflation has proven more persistent than expected, prompting the Federal Reserve to take a cautious approach to potential rate movement. 

Oil prices fell sharply in June before renewed geopolitical tensions pushed them higher again in July. Even after that rebound, prices remain well below the assumptions embedded in our June forecast, creating a modest drag on the near-term outlook. Spot prices are likely to remain volatile in the near term given the geopolitical backdrop. However, we continue to expect oil prices to settle around US$70 in 2027, broadly in line with our previous forecast (chart 2). That level remains above pre-war prices, reflecting a residual geopolitical risk premium.

UNITED STATES: MODERATING GROWTH

Aggregate activity in the U.S. has proven somewhat stronger than anticipated, with first-quarter GDP revised up from 1.6% to 2.1%, supported in part by volatile trade flows and continued strength in business investment. Beneath the headline, however, household spending continues to cool gradually as labour market conditions soften. We expect this trend to persist over the coming quarters, with consumer spending losing further momentum as labour demand is slowing and excess savings fade. Equity market gains should continue to provide some support to consumption, although less so than last year, while persistent inflation is increasingly weighing on real income growth. At the same time, business investment—supported by AI-related spending, strong corporate balance sheets, and elevated equity valuations—should remain an important counterweight and help cushion the moderation in domestic demand.

The other notable development has been inflation. Price pressures have once again surprised to the upside, reinforcing the view that the Fed cannot afford to become complacent. Policymakers now face a more difficult balance: inflation remains persistent, while household demand is slowing and the labour market is weakening. In our forecast, this pushes rate cuts later, though we still expect the Fed to move policy back toward a more neutral stance next year.  

CANADA: EMERGING FROM THE SOFT PATCH

The Canadian economy continues to evolve broadly in line with our expectations. Recent data support the view that activity is beginning to recover from the soft patch experienced at the start of the year. GDP rose a strong 0.5% in April, matching roughly the earlier flash estimate, and recent labour market releases suggest that the anticipated improvement may be arriving somewhat sooner than expected. Although employment gains remain modest, broader labour market conditions appear to be stabilizing after a weak start to the year.

We now expect growth to average 0.9% in 2026, little changed from our previous forecast, although that annual figure masks a meaningful strengthening in momentum through the year. Quarterly growth should firm as the effects of past rate cuts increasingly support domestic demand, particularly in the housing sector and government spending catches up with planned outlays. As a result, we expect GDP growth to strengthen to 2.2% in 2027. The U.S. administration’s refusal to renew CUSMA by the July 1^st deadline does not alter our baseline forecast. Canada’s exports remain protected by the agreement and continue to benefit from very low tariffs. We continue to assume that the free trade framework will ultimately be renewed.

One area we continue to monitor closely is underlying inflation. Momentum has turned somewhat firmer in recent months, with monthly core inflation measures rebounding after a string of softer readings, broadly in line with our expectations. While headline inflation remains relatively well behaved, underlying cost pressures continue to run at levels that are inconsistent with a comfortable return to target. Unit labour costs, IPPI, and our own underlying cost-pressure measure continue to point to elevated inflation risks (chart 3). The recent decline in oil prices is a welcome development and should provide some relief, but we continue to see meaningful upside risks to the inflation outlook. Against this backdrop, the Bank of Canada is likely to remain cautious and lean against the risk of inflation reaccelerating. In our view, these risks warrant a gradual withdrawal of monetary policy stimulus, with the Bank beginning to raise rates twice toward the end of the year.  

RISKS 

• Persistent geopolitical tensions and upside oil price risks. While developments in the Middle East have recently moved in a more constructive direction, geopolitical tensions remain elevated and the risk of renewed disruptions cannot be dismissed. Oil supply continues to be constrained, and inventories are likely to require rebuilding over time, leaving crude prices vulnerable to renewed upside pressure. A sustained rise in energy prices would lift headline inflation directly and raise transportation and production costs more broadly. It could also feed into inflation expectations, amplifying and prolonging price pressures, requiring a stronger monetary policy response (see our previous note on this risk). 
  
• Upside risk from U.S. fiscal policy. Additional fiscal support—including higher defence spending and potential household transfers—could boost demand, add to inflation pressures, and keep the Federal Reserve on a more hawkish path.
  
• CUSMA renegotiation risks. The U.S. administration’s refusal to renew CUSMA by the July 1^st deadline was not unexpected but an adverse outcome to the upcoming CUSMA negotiations remains a possibility and would represent a significant downside risk (see here).