North American Outlook

May 16, 2025 | 15:01

Trading Down

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Key Summary

We assume a temporary ceasefire will set the stage for more clarity in the trade war, but not before economic casualties mount on both sides of the border.
Canada's economy faces a shallow downturn as exports to the U.S. contract, but the expansion should resume later this year as clarity emerges on tariffs. The U.S. economy will decelerate sharply this year.
The Bank of Canada and the Fed will look past higher inflation and focus on a rising jobless rate, reducing policy rates three more times this year by a total of 75 basis points.

Canadian Economy

After gaining momentum in the second half of last year on falling interest rates, Canada’s economy likely faces a shallow downturn as a result of the trade war. While most Canadian goods sold to the U.S. comply with the USMCA and are duty-free, this is not the case for steel and aluminum products, as well as the non-U.S. portion of finished motor vehicles, which face a 25% duty. These tariffs could drive exports sharply lower this spring and summer. Layoffs have already been announced by several automakers, including at GM’s Oshawa plant. Uncertainty about trade policies is already undermining consumer and business confidence. Supply chain disruptions and a less efficient allocation of resources will hinder productivity. Sharp cuts to immigration will also weigh on consumer spending and housing market activity. As a result, after healthy 2.6% annualized growth in the final quarter of last year, real GDP likely slowed to 1.5% in the first quarter and is expected to contract modestly in the second and third quarters. Annual growth is expected to slow to 1.0% in 2025, down from 1.5% in 2024. Ontario, with its significant exposure to the auto and steel industries, will likely suffer the most, though an expansionary budget (and rising deficit) will provide support.

On a more positive note, Canada was spared both reciprocal and baseline tariffs on "Liberation Day". Moreover, levies on motor vehicles exclude the portion made in the U.S.A., effectively cutting the 25% duty in half. More recently, the White House announced that USMCA-compliant auto parts from Canada (and Mexico) would be exempt from levies for at least two years. As a result, the average effective tariff rate on Canadian exports to the U.S. is estimated at around 5%—much less than feared going into the trade standoff in early February. Of course, tariffs could change abruptly (the President recently threatened to impose 100% duties on foreign-made films, which would be a major blow to the Toronto and Vancouver movie industries). However, assuming trade talks are successful, the economy should resume expanding later this year and see 1.2% annual growth in 2026 (and a trend-like 1.9% rate on a Q4/Q4 basis). Growth will also benefit from expansionary fiscal policies. The re-elected Liberal Party ran on a platform of increased spending, modest personal income tax cuts, and larger deficits on the order of 2% of GDP this year, compared with a previous baseline of just over 1%.

Longer term, Canada's economic growth will be influenced by how successful government policies are in attracting capital inflows and business investment, removing internal trade barriers, and helping exporters diversify away from the U.S. and toward other regions. Some of these policies could come at the cost of a larger budget deficit, potentially necessitating higher taxes and cutbacks to public services later on—thereby lowering the country’s long-run growth potential.

Canada's labour market is starting to show the strain from the trade war. Employment fell in March and would have done so again in April if not for temporary election hiring. The jobless rate has risen from 6.2% to 6.9% in the past year, and could hit 7.7% by year-end.

Weaker demand and layoffs will help extinguish any inflation sparks ignited by counter tariffs. Inflation has been volatile due to recent temporary changes in sales taxes, but the annual CPI rate remained low at 2.3% in March and is expected to fall further in April due to the elimination of the carbon tax and falling fuel prices. Several core indices suggest that underlying inflation is running modestly above the headline rate, partly because of inertia in rents and mortgage payments. Counter tariffs on U.S. imports will temporarily lift inflation, but they are far less than initially planned by the government. We look for inflation to hover around the 2% target this year and next in the face of lower energy costs and higher unemployment.

Central banks dislike stagflation for a reason. By pushing both growth and inflation in the wrong direction, it seriously complicates decision-making. After cutting policy rates seven straight times, and by a total of 225 basis points since last summer, the Bank of Canada adopted a more cautious stance in April due to tariff-related uncertainty, and opted to keep rates steady at 2.75%. However, by taking a reactive approach, the Bank risks falling behind the recession curve. We expect it to swing into action at the June meeting, cutting rates three more times this year by a total of 75 basis points, as the unemployment rate rises.

U.S. Economy

The resilient U.S. economy has lost some momentum, largely due to trade war concerns. Real GDP contracted at a 0.3% annualized rate in Q1 due to a surge in imports aimed at avoiding tariff hikes, as well as cuts in federal government spending. An estimated sixfold increase in the average effective tariff on U.S. imports—to around 14%—is expected to significantly reduce growth this year. Thankfully, however, this rate is down sharply from about 26% following a temporary truce that slashed reciprocal duties with China from 125% to just 10%. Still, the economy will suffer. In addition to weaker U.S. exports to China and Canada owing to retaliatory levies, the economy faces some supply chain disruptions, diminished consumer spending power, and ongoing policy-related uncertainty. Large-scale federal layoffs and spending cuts could also weaken the economy. Annual GDP growth is projected to average 1.3% in 2025, down from 2.8% in 2024. Assuming the trade war fog lifts and Congress passes a budget bill to lower taxes, economic growth should improve to 1.4% in 2026.

Employment growth has moderated but remains healthy with nonfarm payrolls rising by 177,000 in April and up 1.2% over the past year. However, large layoff announcements by the federal government (amounting to roughly 10%), coupled with hiring freezes in an anxious private sector, could lead to a material slowdown in job creation. Indeed, layoff announcements outside the government rose sharply in April. While the unemployment rate remains low at 4.2%, it is projected to increase to 5.0% by early next year.

Thanks to lower fuel prices, the CPI rate has fallen to a four-year low of 2.3% year-over-year in April. The core rate (excluding food and energy) also stands near four-year lows of 2.8%. However, tariffs are expected to push inflation to 3.5% by late this year, before a moderating trend resumes in response to weaker demand and looser job market conditions.

Faced with unprecedented uncertainty, the Fed will likely delay interest rate cuts for a couple more months. Chair Powell has stated there is no urgency to ease policy, as the economy is healthy and core inflation is still somewhat elevated. Nonetheless, assuming tariffs do not boost long-run inflation expectations, policymakers are likely to address higher unemployment by cutting rates a cumulative 150 basis points between July 2025 and June 2026.