Understanding Why the Central Bank Hasn't Cut Interest Rates to 2.5%

First, this is important to understand because it helps businesses predict when interest rates, and therefore, debt, will be relatively low. This can help manage capital reserves in advance of expansionary periods and take advantage of the uptick.

Now, obviously, the central bank's interest rates follow the Taylor rule most closely (which suggests that policy rates are set based on inflation and the output gap (if GDP is low relative to expected GDP, lower rates to stimulate economy)). However, I am not surprised Canada has not seen another interest rate cut since the tariff situation. Why?

The central bank holds and manages our currency reserves. Effectively, when local businesses obtain foreign currency, they will print money (through bond issuance) and exchange it for the foreign currency, creating reserves. Now, typically, this offers a negative carry rate of return because the bonds they issue in foreign currency usually have higher interest rates than those in domestic currency (they pay more). As you can imagine, if our currency depreciates (also known as inflation) then they will need to hold more foreign exchange reserves.

There's a lot of factors in currency valuations, but generally think macroeconomic conditions: Are policies pro-business? Is there a trade deficit? Etc. One important factor is interest rates and we can think through them with the Mundell-Fleming model, which, says that if capital can easily move across the border then interest rates are the primary determinant of currency value because investors want better rates of return. If interest rates are high, it attracts more capital, creating demand for the currency, and therefore increasing the price (currency appreciates). On the other hand, low interests do the opposite.

So, all of this to say, the central bank needs to balance currency value (which will go down with low interest rates) with GDP growth. Of course, the trade pressure coming from the US also puts some uncertainty into the CAD value. The best course of action appears to be, as the central bank implied prior to the 'shocking' rate hold by emphasizing currency stability (not to mention inflation was below the traditional 2% target at the time; sometimes it seems like the experts have left the market), to hold interest rates as they are. We probably won't see another rate cut until more certainty comes in the form of new trade deals, which will probably be mid-late of the Q3.