EconoFACTS
February 02, 2025 | 12:45
Trade War Impact: First Pass
Economics
Economics
Overview On February 1, U.S. President Trump signed an executive order imposing a 25% tariff on all non-energy imports from Canada and a 10% tariff on energy imports (effective February 4). In separate executive orders, a 25% tariff was levied on all imports from Mexico and a 10% tariff was put on all imports from China. These rates are in addition to any tariffs or duties already charged. He invoked the International Emergency Economic Powers Act (IEEPA) to apply these tariffs. After declaring a national emergency at the southern border (January 20) due to “the influx of illegal aliens and illicit drugs”, the President expanded this to cover “the public health crisis of deaths due to the use of fentanyl and other illicit drugs”. And, specifically, “the failure of Canada to do more to arrest, seize, detain, or otherwise intercept DTOs [drug trafficking organizations], other drug and human traffickers, criminals at large, and drugs”. Furthermore, this failure by Canada “constitutes an unusual and extraordinary threat… to the national security and foreign policy of the United States”. The order also said: “Should Canada retaliate… the President may increase or expand in scope the duties imposed under this order”. Canada subsequently announced 25% retaliatory tariffs on It’s uncertain whether: 1) the U.S. will retaliate for Canada’s retaliation; 2) the Administration will heed the calls from U.S. businesses for exemptions (the aluminum industry is already on record); and 3) if the executive order will survive legal challenges, or when the President will be satisfied that Canada’s 'failure' has been remedied. However, by April 1, there will be three reports delivered to the President (under the America First Trade Policy memorandum) that should be full of tariff recommendations backed by investigations (or soon-to-be), setting the stage for more Section 201 (safeguard), Section 232 (national security) and Section 301 (unfair trade practices) tariffs. In consequence, tariffs on Canada and other countries could be around for a while. Given this backdrop, we are adjusting our forecasts, as outlined below. This is clearly a fluid situation, and further adjustments may be required in the weeks ahead, as more information comes to light in terms of Canada's fiscal response, as well as any potential U.S. countermeasures, or even a possible off-ramp for the tariffs. For now, we are incorporating the information on hand, and assuming that the tariffs will be in place for a year. |
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Economic Impact on Canada ... Trump’s tariff hammer will come down hard on Canada’s economy. If the announced tariffs remain in place for one year, the economy would face the risk of a modest recession. A couple quarters of contraction are well within the realm of possibility. With little confidence given the lack of historical precedent, we estimate that the tariffs will reduce real GDP growth by about 2 ppts to roughly zero in 2025. This reflects reduced demand for Canadian exports to the U.S. (which account for about a fifth of GDP), disrupted supply chains impeding business activity and consumption, and heightened uncertainty that reduces business investment. It also reflects a reduction in domestic demand due to higher prices stemming from retaliatory tariffs and a weaker Canadian dollar. The estimated growth hit is a bit lighter than the Bank of Canada's recent scenario (it called for about a 2.5 ppts reduction in GDP growth for the first year), due to the lesser 10% tariff on energy products, as well as the fact that Canada's retaliation is measured. However, we recognize the difficulty in modelling such an extreme event, and certain sectors may not behave in a predictable pattern—e.g., the highly integrated auto industry. CPI inflation is expected to rise less than one ppt this year from the current 1.8% rate in December. But given growing slack in the economy and a likely more-than-one ppt increase in the unemployment rate to around 8%, inflation pressures should remain subdued, allowing for some moderation in 2026. Partly limiting the economic pain will be a weaker currency, lower interest rates, and an expected government relief program for jobless workers and affected businesses. These supports, along with the assumed revoking of tariffs after one year, should lead to a modest recovery in real GDP growth to about 1% in 2026. From a sectoral lens, a wide range of Canadian industries derive at least half of their revenue from U.S. exports. Near the top of the list is motor vehicles, but others with high exposure include auto parts, clothing, wood products, chemicals, medicines, rubber, iron and steel, aluminum, machinery, computers, and electrical equipment. In agriculture, tobacco, greenhouses, sugar, and seafood stand out. While the oil industry has very high exposure, we assume the 10% tariff will have little dampening effect on U.S. demand given a combination of a weaker loonie, Canadian producer price cuts, and U.S. refinery cost absorption. The housing market recovery in Canada, as gradual as we expected it to be in the absence of tariffs, could be dampened this year by the confidence-sapping trade war, before resuming in 2026 on lower mortgage rates. It is somewhat encouraging that the U.S. executive order keeps the door open for revoking the tariffs if the said national emergency “crisis is alleviated”. In the event the tariffs prove short-lived, we would unwind the downward revisions to growth. However, the order also warns that the President could increase tariffs further in response to retaliatory actions, which would raise the risk of a deeper economic downturn. The potential long-term damage to Canada’s economy cannot be dismissed, either. Many businesses will increase production on the other side of the border to avoid tariffs. The uncertainty alone about further protectionism could put a chill on business investment for years, which is why the government’s response should also be directed at encouraging productivity-enhancing investment. This was already a necessity before tariffs given the new U.S. administration’s planned pro-business policies, including corporate tax cuts and lighter regulations. |
... and the Provinces Direct exposure to U.S. trade varies across the country, and so will the impact. B.C. carries a relatively low share of goods exports in its economy, and roughly half of those are destined for markets outside the U.S, but some industries (e.g., forestry) will come under duress. Alberta, Saskatchewan and New Brunswick, because of hefty energy exports, carry the largest exposure (exports to the U.S. are 25%-to-36% of GDP); but, the lighter 10% tariff on such products, and the assumption that a portion will be passed to the U.S. consumer, leaves the impact to run smaller in these provinces—at least in the short run. Non-energy U.S. export exposure is highest throughout Central Canada. In Ontario, for example, U.S. goods exports top 17% of GDP with a wide range of industries exposed (e.g., autos, machinery, metals and consumer goods). Quebec’s industrial metals and manufactured goods will be vulnerable, as will Manitoba’s diverse manufacturing base. Atlantic Canada is susceptible because of a few highly-concentrated industries, even if the broad economic impact appears smaller—think the Newfoundland & Labrador fishery, and PEI packaged food goods. All told, we expect the economic impact to hit hardest in Ontario and the rest of Central Canada; significantly impacting some concentrated industries in Atlantic Canada and B.C., while dealing a lesser immediate blow in oil-producing provinces. |
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Rates and the CAD The Bank of Canada’s rate cut last week was partly portrayed as a risk management move compelled by the rising risk of U.S. tariffs. With that risk now being realized, we reckon the Bank will lean against the expected significant economic slowdown and steeply escalating risk of recession along with associated disinflationary pressures. However, there will be a measure of caution in the policy easing, with inflationary pressures simultaneously prodded by retaliatory tariffs and Canadian dollar depreciation. Previously, we projected the Bank would cut the policy rate two more times this cycle, by 25 bps in April and July (ending at 2.50%). We now look for the quarter-point pace to continue each meeting until October, thus ending at 1.50%. The net risk is that we get to the endpoint sooner. With the Fed forecast to continue its current pause until June and then resume a quarterly 25-bp rate cut clip, this means Canada-U.S. overnight rate spreads are going to push past -225 bps, testing the all-time extreme of -250 bps during the spring of 1997. With medium- and long-term Canada-U.S. bond yield spreads recently smashing through record negative levels, the market has been sensing extreme overnight spreads too. This will no doubt add to the Canadian dollar’s woes along with appreciation in the greenback as America’s tariffs go global. We see the loonie averaging around |
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Economic Impact on the U.S. Unfortunately, the tariffs announced on Canada, Mexico, and China proved as broad-based and comprehensive as we feared (approximately 43% of all U.S. goods imports). This will likely cause near-immediate supply chain disruptions in a number of industries (motor vehicles and parts the most obvious sector to watch), shortages of some products in stores, and a near-term price spike for many imported goods from America's three largest trading partners. We also expect an upswing in financial market volatility as market pricing resets to the newly evolving macroeconomic landscape, and increased policy uncertainty. Incorporating the U.S. tariff increases and retaliation from Canada and Mexico announced so far, and assuming these higher tariffs remain in place a full year, we are marking down our baseline U.S. GDP growth forecast for full-year 2025 by 0.3 ppts to 2.1% and the 2026 call by 0.2 ppts to 1.8%, while lifting our core PCE inflation estimates by 0.3 ppts in each year to 2.8% and 2.4%. On a Q4/Q4 basis for 2025, we see growth at 1.7%, down from 2.2% previously, and core PCE inflation at a higher 3.0% instead of 2.4%. Note, these forecast changes are preliminary and could move considerably in the weeks and months ahead due to financial market behaviour, as well as monetary and fiscal reactions, and if the new tariffs prove shorter-lived than assumed, or additional tariffs and retaliations are announced. Should the U.S. administration broaden the trade war to other nations, including much of Europe, as it has threatened, the economic harm will escalate, and we will need to revisit our forecast. On the other hand, a possible early withdrawal of tariffs would set the U.S. economy back on course for another solid year of growth. |
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Please see our previous research on the upcoming tariffs:
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