In the lead-up to this year’s U.S. elections, there are three dominant and disparate topics in the Canada-U.S. relationship that bear watching: trade, immigration, and a growth/inflation divergence.

• Trade is coming into sharper focus ahead of the November U.S. vote. While China draws the most attention, the U.S. bilateral deficits with both Mexico and Canada have widened in recent years, heightening the risks around the USMCA review in 2026.

• Immigration has been a driving force in both economies: While the fastest population growth in almost 70 years has grabbed the headlines in Canada, the U.S. has also seen a rapid rise in labour force growth recently.

• Growth has diverged markedly between an amazingly resilient U.S. economy and a struggling Canadian consumer in the past year. We believe this is a short-term cyclical event, which will give way to convergence over the medium term. Indeed, despite recent gloom around Canada’s growth backdrop, it could slightly outperform in the next few years.

1) Industrial and Trade Policy: Trade in a Time of Chaos

With the U.S. election fast approaching, no area of economic policy has received more attention than trade and industrial policies. Both political parties in the U.S. have moved toward a more protectionist stance in the past decade, targeting semiconductor and other emerging technologies, solar panels, EV purchases, and other green energy sectors. In particular, subsidies and tax incentives have seen strong take-up. The Congressional Budget Office (CBO) recently estimated the energy components of the 2022 Inflation Reduction Act could cost US$800 billion over ten years, more than double the initial estimate of $391 billion.

In addition, both parties have placed high import tariffs on legacy industries that have faced increasing competition with China. Most recently, President Biden imposed or raised tariffs on approximately $18 billion worth of annual imports from China, including semiconductors, solar cells, advanced batteries and critical minerals, and electric vehicles. He is also maintaining President Trump’s earlier tariffs on over $300 billion worth of Chinese goods. As a result, the share of U.S. goods imports from China has been nearly cut in half since its peak in October 2017 (Chart 1).

Donald Trump has indicated that, if re-elected, he would restrict investment between China and the U.S., ban some Chinese products from the U.S., and revoke China’s “most favored nation” trade status. Moreover, he would subject all imports, regardless of their origin, to an additional 10% tariff and impose a new tariff of 60% or more on all imports from China.

On net, higher tariffs are expected to weigh on U.S. GDP growth, as the hit to real income and spending from higher prices outweigh the improved trade deficit and tax revenue, especially if other countries retaliate as expected. Additional indirect impacts could include a sharp deterioration in financial conditions and business and consumer sentiment, along with more uncertainty in trade policy. Tariffs can effectively be a regressive tax on domestic consumption, i.e., the burden is largely borne by lower-income households as a higher share of their income goes to spending. According to the Peterson Institute for International Economics, Trump’s proposed tariffs would reduce after-tax incomes by about 3.5% for those in the bottom half of the income distribution. Altogether, the proposed new tariffs on China and the rest of the world would cost U.S. consumers at least 1.8% of GDP before accounting for retaliation and lost competitiveness—nearly five times larger than the cost of the 2018-2019 U.S.-China trade war (Table 1).

These measures could also temporarily raise broader inflationary pressures, countering the Fed’s goal of returning inflation to target. Studies from the 2018-19 tariff increases show the impacts fell almost entirely on the U.S. consumer and provided cover for domestic producers to also raise prices. Still, the overall inflation impact should be relatively modest, with each 1 percentage point increase in the effective tariff rate expected to lift U.S. core consumer prices by around 0.1 ppt. Given Canada’s reliance on U.S. trade, a portion of the inflationary effects from higher U.S. tariffs may flow through to Canadian consumer prices in turn.

As of 2023, Canada was the United States’ second-largest trading partner, moving back above China, but dropping below Mexico (Chart 2). Canada was the top destination of U.S. exports (about 17% of the total) and third-largest source of U.S. imports, behind China and Mexico. Canada’s share of U.S. imports has trended down from around 20% in the mid-1990s to just above 13% now.

However, one potential concern is the extent to which the U.S. bilateral trade deficits with both Canada and Mexico have swelled in recent years (Table 2). While not nearly as lopsided as U.S. trade with China, the recent imbalances with these two trading partners could become a political flashpoint for the next U.S. Administration. So far, U.S.-Canada bilateral trade has largely side-stepped the worst of this protectionist pivot, somewhat shielded by the 2020 USMCA. Even so, the Trump Administration raised tariffs on steel and aluminum from Canada, along with most countries, from mid-2018 to May 2019, when the tariffs on Canada were lifted as part of the USMCA negotiations. The USMCA is due for review in 2026, potentially pulling Canada and Mexico directly into the U.S. protectionist orbit. In Canada’s case, the vast majority of the wider trade imbalance has been driven by the back-up in energy prices, as well as some increase in oil volumes. Nevertheless, the combined share of the U.S. trade deficit from Mexico and Canada has pushed above 20%, comparable to the European Union and not far below that of China.

While headline trade imbalances with the U.S. have narrowed between China and the USMCA partners, we note two things: 1) Some of China’s exports to the U.S. are likely being re-routed through third parties and then partially upgraded to avoid tariffs, understating the bilateral U.S.-China imbalance, while potentially overstating Mexico’s imbalance; and 2) the ratio of U.S. exports to imports is still much, much healthier with Canada (85.0% in the past 12 months), and with Mexico (67.2%), than with China (34.2%). In other words, there really is no equivalent comparison between the overall imbalance in trade flows with the rest of North America and that with China.

Finally on trade, Canada (and Mexico) could face additional challenges on trade policies aside from USMCA renewal. For instance, if Canada is compelled to move in lock-step with the U.S. on tariffs on Chinese EVs and other products, it could spark bilateral trade pressure from China. This could hit Canada harder given China's importance as a destination for Canadian agricultural and forest products.

2) Immigration: Large Shifts

The U.S. has seen a large influx of immigrants since the pandemic reopening began. The CBO estimates that 3.3 million net immigrants arrived in the U.S. in 2023 (or roughly 1% of the resident population) compared with around 1.0 million a year prior to the pandemic (Chart 3). The CBO estimates that strong migration will continue at least over the next two years before moderating back toward pre-pandemic levels.

At the same time, net immigration in Canada has reached record highs, with population growth at its highest pace since the late 1950s (3.2% y/y as of the start of 2024). New immigrants skew younger, bolstering the prime age working population at a time when the domestic population is aging. The Canadian government’s recently announced caps on international students and non-permanent residents (details of which will be announced later this year) are expected to bring Canada’s population growth down to a more manageable 1% y/y pace starting in 2025.

In the near term, the immigration surge has added to demand for housing, transportation, food, health care, and other services. At the margin, this likely contributed to elevated price pressures, especially when housing markets were particularly tight.

Yet, many of these new immigrants have bolstered employment metrics over the last two years, helping to rebalance labour supply. In the U.S., the BLS estimates the labour force participation rate for immigrants in 2022 was around 50%. Statistics Canada estimates that the participation rate for immigrants landed in the past five years is now above 70%—that’s higher than the overall rate of just over 65%, likely reflecting the younger demographic of recent arrivals. In both countries, higher immigration rates mean that employment growth doesn’t need to slow as significantly to bring the labour market into better balance.

For instance, a 2024 paper by the Brookings Institution estimates the U.S. labour market can now accommodate monthly employment growth of roughly 160,000-to-220,000 without adding pressure to wages and price inflation. This was especially evident in last year’s stellar job and real GDP growth performances even as consumer inflation rates moderated swiftly. However, the upcoming U.S. election significantly increases the uncertainty over immigration policies and, thus, the estimates of potential non-inflationary job growth.

In Canada, the rise in population has been nothing short of dramatic in recent years. Even smoothed over a five-year period, population has risen at a 1.8% annualized rate, the fastest sustained growth pace in more than 50 years. Temporary foreign workers are the top factor, but a large share of the surge is driven by international students, as well as by refugees, who may not necessarily join the workforce. As well, the peak of the Baby Boom is reaching retirement age, so overall Canadian labour force growth has not been nearly as steep as total population. But compared to the United States, Canada’s labour force has been growing at roughly twice the pace of the U.S. workforce over both the past 5 and 25 years (Chart 4).

Notably, the wide gulf in Canada/U.S. population and labour force growth has clearly not translated into faster economic growth for Canada. A much weaker productivity performance in recent years has resulted in Canada actually lagging behind the U.S. in real GDP growth over the past five years (Chart 5). Even over the longer term, both countries have posted nearly identical GDP growth rates over the past 25 years (2.1% for Canada, 2.2% in the U.S.), even though Canada’s labour force has expanded almost twice as quickly on average over that period (1.4% versus 0.8%).

3) U.S.-Canada Growth Divergence: This, Too, Shall Pass

Unfortunately, the underperformance in Canada’s economic growth relative to the U.S. has deepened in the past year. Looking through the quarterly wobbles, real GDP in Canada is up by less than 1% in the past four quarters (to 2024 Q1) versus nearly 3% U.S. growth over the same period.

This widening gap is primarily driven by the greater sensitivity of Canadian consumers to higher interest rates than their U.S. counterparts, due to a much higher concentration of short-term fixed-rate mortgages and much larger debt loads (Chart 6). The Canadian mortgage market is largely comprised of variable rate and shorter-term fixed rate mortgages, typically five years or less (versus the availability of 30-year fixed-rate mortgages in the U.S.). Normally, this difference in mortgage terms doesn’t have a large bearing on growth differentials—but these are clearly not normal times, given the extraordinary rate hikes in 2022/23. We’ll note that amid all the clamouring for the option of much longer-term mortgages in Canada, U.S. 30-year mortgage rates are now hovering around 7%, far above the five-year rates on offer in Canada of closer to 5%.

While there is a great deal of negativity currently swirling around Canada’s growth performance, we believe that there are grounds for optimism over the medium term. Strong population growth and earlier rate cuts are important drivers of our forecast for a notable rebound in Canada’s real GDP growth in 2025—back to around 2%. The relatively weak growth of 2023/24 has allowed inflation to cool more rapidly, bringing it back within the Bank of Canada’s 1%-to-3% comfort zone, and within sight of the 2% target.

Another reason for some guarded optimism on the relative growth outlook for Canada is the fiscal backdrop. While far from pristine, Canada’s fiscal fundamentals are much less concerning than those of the U.S. and many European economies. The IMF’s latest Fiscal Monitor estimates that Canada’s general government budget deficit of just over 1% of GDP this year will be well below that in Europe (2.9%) and the U.S. (6.5%), implying the need for a lesser degree of restraint over time. We believe the IMF is a bit too lenient in Canada’s 2024 estimate, as this year’s budget cycle points to a combined federal & provincial deficit of just over 2% of GDP. Still, this is on the low side of major economies and is essentially a non-negative for the Canadian outlook, as many other economies face the prospect of some serious fiscal restraint in coming years. For longer term consideration, the IMF also reports that Canada’s general government gross debt will rise to nearly 105% of GDP in the coming year, well below the U.S. (at over 120%), but in line with the U.K. and above Germany.

Pulling these strings together, the current growth and inflation gap between Canada and the U.S. will lead to some short-term divergence in monetary policy and some additional softness in the Canadian dollar. In turn, these forces could aggravate the bilateral U.S.-Canada trade imbalance—amid ongoing sluggish Canadian spending (and imports) and an even more competitive exchange rate. However, we suspect that the U.S.-Canada growth gap will soon narrow; the sensitivity of Canadian consumers to interest rates will turn from a drag to a lift as borrowing costs recede.

Appendix

Some other key facts on the Canada-U.S. trade relationship:

• The USMCA region has surpassed the US$1.5 trillion mark as a regional trading bloc (intra regional trade flows) and the Canada/U.S. relationship comprises more than half of those total flows. The regional bloc now accounts for almost 30% of global GDP. Based on IMF data for 2023 nominal GDP in U.S. dollars, the figures are 26.1% U.S., 2.0% Canada, and 1.7% Mexico.

• Consumers benefit from the USMCA relationship primarily through three channels: (1) it helps lower consumer prices by preserving duty-free access to goods and services from within the trading bloc; (2) the relationship directly supports 9.5 million jobs; (3) it creates better opportunities for firms to achieve economies of scale enhancing productivity (which can lead to further improvements in consumer prices)

• Thanks in part to the USMCA, U.S. trade volumes with Canada and Mexico are now 44% higher than with China, providing important national-security relevant trade diversification away from China. The potential for Canada and Mexico to be important spokes in the emerging critical mineral supply chain can further allow the United States to align its economic and national security goals. The U.S. is also the largest destination for Mexican and Canadian investment.

Mexico stands to benefit from efforts related to nearshoring with some estimates suggesting its exports could grow by $35 billion over the next few years. Inward FDI in Mexico surged 48% to start 2023 compared to 2022Q1 with roughly half of those funds originating from Canada and the United States.