Could a Weak Canadian Dollar Lead to Increased Inflation?

As Donald Trump takes office in the US, the threat of punishing tariffs could ripple throughout the Canadian economy, including higher inflation.

It’s not just the direct impact of a potential trade war, where Canada would tax US goods in retaliation. But also the secondary effects such as a continued decline in the Canadian dollar. Higher inflation ultimately means the Bank of Canada will be limited in its ability to make additional interest rate cuts.

But economists say that investors, and Canadian consumers, shouldn’t panic unless the Canadian dollar collapses by well over 10%.

Why is the Canadian Dollar Falling?

Over the past year, the Canadian dollar has fallen some 8%, trading now around C$1.44, compared to C$1.33 at the start of 2024. The Canadian dollar was hovering at USD 0.69, as of Jan. 17., tumbling from a high of USD 0.75 in January 2024.

The catalyst for the decline has been the macroeconomic headwinds including the threat of steep tariffs on Canadian goods imported by the US, a domestic economy teetering on the edge of recession, and the large and growing gap between monetary policies of central banks on either side of the US-Canada border.

Will Inflation Rise if the Canadian Dollar Keeps Falling?

Now, there is a growing concern that the softening Canadian dollar may not get a reprieve any time soon and could rekindle domestic inflation. Canada is a large importer of US goods including food, energy, electronics and many other everyday items. When the Canadian dollar weakens, the cost of these goods increases. Businesses have to pay more to import these articles, the higher cost of which gets passed onto consumers.

The question is, how much of a jump could be in the cards?

Desjardins macro strategist Tiago Figueiredo points to the Bank of Canada’s own estimates.

“The Bank of Canada estimates that 10% depreciation in the currency leads to around a 0.25 percentage point increase in inflation [excluding] food and energy,” Figueiredo says. “That’s a good starting point to think about the impact on inflation, [but] I wouldn’t be concerned unless we start to see the Canadian dollar break below [USD] 65 cents.”

Nathan Janzen, assistant chief economist, Royal Bank of Canada shrugs off the hike in core inflation that a 10% loonie depreciation could generate over the year before fading off.

“That’s a significant amount, but likely not enough to offset the disinflationary impact of a weakening economy,” he in a note to investors.

What’s the Impact on Consumers from a Weaker Canadian Dollar?

Much of what Canadians consume is produced domestically, he argues, noting that only 20% of Canadian consumption is accounted for by foreign production, half of which comes from the US.

“A weaker loonie will surely increase the cost of imported goods, particularly products like gasoline, fresh fruits, and vegetables, but for the vast majority of consumer spending, that is not imported,” he adds.

Further, weak domestic demand will continue to suppress rather than stoke price pressures.

Other than gasoline, prices for imported products such as electronics tend to move far less in tandem with near-term currency fluctuations, Janzen says.

Goods such as motor vehicles, which rely heavily on cross-border production, are also less sensitive to the exchange rate as the price impact can get washed out from all the re-imports and re-exports component products at different production stages, Janzen notes.

Figueiredo says that the inflationary effect of the loonie weakness might be more pronounced on some product categories. “Food prices is the one that most folks point to, especially during this time of year where local produce isn’t as abundant,” he says.

For the foreseeable future, the Canadian economy will have to negotiate the push-and-pull of two opposing forces working simultaneously.

“The hope is that a weaker currency boosts demand for exports, but if our exports are being tariffed, that transmission to the economy might not be as effective,” says Desjardins’ Figueiredo.

Canada’s Response to Tariffs

If Canada responds to US taxes by imposing counter-tariffs on US exports, as the Liberal government plans to, consumers could be encouraged to go local for their consumption needs. In the event of retaliatory Canadian tariffs, “consumers and producers could shift purchases away from US suppliers to domestic producers, a dynamic that could be even further amplified with retaliatory tariffs,” Figueiredo says.

Such a scenario would help boost the domestic economy at a time when Canadian producers might struggle to keep their export operations humming.

Donald Trump is expected to sign over 100 executive orders on the first day of his presidency. Market watchers say the extent of the impact of his policies will depend on whether he takes a “fast announcements and slow implementation” approach or opts for a harsher “fast announcements and fast implementation” path. It’s the latter prospect that investors fear the most, and “concerns we think market prices already reflect from a probabilistic standpoint,” says a Morgan Stanley note to investors.

“If coming executive orders surprise with faster-than-priced implementation of tariffs and/or larger-than-priced increases, then we would expect the US dollar to appreciate – particularly against the CNY [the Chinese yuan], CAD [the Canadian dollar], and MXN [the Mexican peso],” the note says.

Canada’s Foreign Investment Hedges Currency Weakness

Analysis also point to Canada’s export advantage and income-generating foreign assets as a bulwark against a lower exchange rate.

Canada is a net creditor to the world, with a larger amount of foreign currency assets than foreign currency debts held abroad, says RBC’s Janzen. “This means a weaker loonie, on balance, will increase Canada’s national net international investment position when measured in Canadian dollars,” he says.

Canada’s international balance sheet naturally hedges against currency weakness, which is helpful in bolstering investor confidence, “making a downward currency spiral less likely to begin with,” Janzen adds.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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