Paths Forward (and Backward) for Free Trade

Scenarios for the U.S.-Canada Economic Relationship

This is an abridged edition of a special report published by BMO Economics on October 6^th. Please click here for the full report.

The United States and Canada have enjoyed a long and fruitful relationship that dates back more than 150 years and has grown to encompass deep economic, cultural, and political ties. Side by side, our countries prevailed in both world wars and the Cold War, and with the triumph of the West at the dawn of the 1990s, unprecedented steps were taken to thin our common border and integrate our economies. Those earlier steps toward integration were always understood to be part of a one-way trip, but that assumption is now being challenged.

This year’s U.S. trade conflict has created a tense and potentially combustible environment heading into the upcoming CUSMA/USMCA review, which is slated to begin by July 1, 2026. The review process is part of the USMCA’s sunset mechanism, which stipulates that the deal automatically expires after 16 years unless all three member countries agree to extend it. On one hand, there is a long runway. If the parties cannot reach an agreement next year, the review process is to be repeated annually, and the agreement will expire only if no compromise is reached by 2036. However, there is also a nuclear option, as any party can unilaterally withdraw with six months notice.

U.S. administration officials have already made it clear that they intend to renegotiate the USMCA, rather than renew it in its current form. There is no shortage of recurring trade irritants that could end up being tabled. On the U.S. side, auto content rules, supply management, intellectual property, and cross-border investment could be front and centre. Canada’s strategy, in contrast, will necessarily be more reactive as it strives to maintain valued protections in a relationship that will always be deeply lopsided. For both sides, but especially Canada, there is a lot at stake. A constructive outcome would help assure businesses and investors that the North American economic project remains intact; a bad one could upend continental trade and the economy.

Economic forecasting is challenging at the best of times, which these are not. With politics and personalities at play more than economics, the path forward for U.S.-Canada trade is difficult to anticipate and the range of possible outcomes is wide. Rather than trying to predict the unpredictable, we estimate the potential economic impact of several stylized scenarios, ranging from relatively benign to extremely damaging. Our aim is to establish a handful of useful reference points while acknowledging that reality could ultimately fall somewhere in between.

We make a number of simplifying assumptions. First, we narrow our consideration to North American trading arrangements and assume that terms between the U.S. and overseas partners remain little changed. We confine our analysis only to various tariff outcomes, which are assumed to become effectively permanent. Canada is assumed to partially match U.S. tariffs, which would be a departure from the structures that the U.S. has negotiated with other countries. For the purpose of estimating U.S. impacts, Mexico is assumed to accept similar terms to Canada. Economic impacts incorporate an expected central bank response, but not a fiscal reaction, which is less certain in size.

Our overarching conclusions are summarized in Table 1.

Scenario #1: Free Trade Muddles Through

A benign outcome: 7% average tariff in U.S. (i.e. no change) and 2% in Canada

It’s worth recognizing that the U.S.-Canada relationship could still get through this rocky patch mostly unscathed. Rhetoric aside, politicians on both sides seem to recognize the damage that broad tariffs would do to the North American economy and its competitiveness in global markets. Even the U.S. administration seems to appreciate the perils of abandoning free trade completely, which would weigh heavily on the manufacturing sector, one of its key constituencies. If the President thought broad tariffs against Canada were a good idea, they would probably already be in place.

In a “Muddle Through” scenario, continental free trade mostly endures, with no across-the-board tariffs imposed by either side. However, sectoral U.S. levies remain in place for steel, aluminum, lumber, and select other products. The average U.S. tariff rate on imports from Canada remains around 7%, where it stands today. Otherwise, the administration is assumed to settle for minor adjustments and perhaps non-trade commitments on border security and defence. In this scenario, Canada adds modestly to its existing countermeasures, but not so much as to provoke a further U.S. response, raising its average tariff rate to 2% from less than 1% today. The new tariffs could be accepted as part of an amended USMCA or a new trading framework, or the two sides could dispense with formalities and leave the USMCA question for another year.

This is not a best-case outcome, which would have both sides dismantle all tariffs, yielding better economic conditions than described here. However, it would still be a welcome result after nine months of turbulence. It’s also a reasonable baseline expectation (i.e., most likely path forward), and as such, our official macroeconomic forecast is built upon roughly this operating assumption. Importantly, even if average tariffs remain fairly low, it is doubtful that any agreement could fully assuage fears about a future flare-up in tensions. After all, the USMCA has offered only limited shelter from this year’s instability.

On its own, a “Muddle Through” scenario would have a small macroeconomic impact in the U.S., given its much larger economy and lesser reliance on trade with Canada (and Mexico). Over time, economic activity would end up perhaps a tenth lower than otherwise, and the price level perhaps a tick higher. However, these figures represent the stand-alone impact of greater frictions in continental trade, which accounts for less than one-third of the U.S. total. Imports from other U.S. trading partners are facing significantly higher tariffs, which will yield a larger impact on U.S. growth and inflation.

In Canada, sectoral tariffs and lingering uncertainty would create a more noticeable drag for the economy. Business investment would remain under pressure. Some companies could benefit from comparatively better access to the U.S. than their overseas competitors, but many would be hesitant to expand capacity in Canada. The labour market would likely weaken somewhat further, though widespread job losses would be unlikely and improved confidence would eventually support consumer spending. Export volumes would slide, especially in industries targeted by tariffs, but a weak loonie and sluggish import growth would prevent net trade from weighing excessively on the economy. Over time, Canadian economic activity would fall perhaps 1%-to-2% below the path expected at the start of 2025; the economy would continue to grow, but at a subdued pace. Inflation could initially slow somewhat in the sluggish growth environment, but prices would eventually adjust around 1% higher due to the weak currency and domestic tariffs on some U.S. imports.

Scenario #2: No Special Treatment

An adverse outcome: 15% average tariff in U.S. and 5% in Canada

One discernable pattern through all of this year’s instability is that the administration has repeatedly tried to establish a broad regime of low-double digit tariffs. In April, when it suspended the large reciprocal tariffs that had put markets into a tailspin, the 10% global baseline tariff was retained (though it was not applied to Canada and Mexico). In subsequent trade deals, the administration secured similar tariff rates in the 10%-to-15% range with some of its largest trading partners. It could be that the possibility of very large tariffs is being used to make moderate ones more palatable.

In a “No Special Treatment” scenario, the U.S. imposes across-the-board tariffs averaging 15% on imports from Canada, though levies could be higher in some sectors. The administration either withdraws from the USMCA, disregards it, or establishes the tariffs as part of a new trade framework, as it has with other countries. Unlike overseas partners, Canada is assumed to retaliate with tariffs of its own—a conservative assumption that results in a larger economic impact. But, cognizant of the costs and fearful of inciting U.S. escalation, the average Canadian tariff rate is kept to a lesser 5%. In this scenario, as well as the more severe scenario that follows, both sides are assumed to implement tariffs only on the non-domestic content of imported products, so that tariffs don’t compound repeatedly in cross-border industries like vehicle production (existing U.S. auto tariffs operate in this manner).

Such a scenario, while worse than the status quo, would still have a limited macroeconomic impact in the U.S. For the most part, Canada’s 5% average tariff could be absorbed into profit margins or passed into prices without too much impact on activity, though higher levies could have a greater impact in some industries. Overall, such an outcome could carve perhaps 0.4% from U.S. real GDP over several years, relative to earlier growth expectations, while adding around 0.4% to prices. On its own, it would represent a manageable growth headwind and give a temporary lift to inflation. It would be unlikely to move the needle for the Federal Reserve but would add to damage caused in other theatres of the trade dispute.

The economic impact in Canada would naturally be more significant, yet still manageable. Job losses in the most trade-oriented industries would weigh on consumer spending and wage growth but would be unlikely to cascade across the broader economy. Business investment and exports would decline materially, but net trade would be supported by lower imports and likely a modest further depreciation of the loonie. Growth would slow noticeably and, over time, economic activity could fall around 2.5% below pre-tariff trends. A technical recession would be a strong possibility, but any downturn would probably be short-lived. Tariff revenues would be significant and would almost certainly be recycled to support affected industries.

Although greater economic slack could initially weigh on inflation, the Bank of Canada would remain wary of longer-term pricing pressures and would be hesitant to cut rates much below 2%. After complete adjustment, which would likely take several years, consumer prices could rise by perhaps 1%-to-2%. The increase in prices would reflect the higher cost of U.S. imports, less efficient small-scale production of domestic replacements, and greater transportation costs for overseas substitutes.

Scenario #3: Continental Divide

A worst-case outcome: 35% average tariff in U.S. and 15% in Canada

Unfortunately, it is also possible that USMCA negotiations could go off the rails. Hardline negotiating tactics on either side could backfire. In Canada, the public may want to go toe-to-toe in any negotiating row despite the two countries’ very different weight classes. Meantime, U.S. negotiators are keenly aware that they have much less on the line than Canada and could press that advantage. Cooler heads may not prevail.

In a “Continental Divide” scenario, we assume that the U.S. implements a 35% tariff wall against all imports from Canada. That is the current rate being applied to non-USMCA products and will serve as a natural reference point in negotiations. Canada, in response, imposes an across-the-board 15% tariff on imports from the U.S.—enough to avoid the appearance of bending the knee, yet calibrated to avoid further escalation. As above, it is assumed that tariffs apply only to foreign content, which helps to limit the damage. This is not literally the worst outcome imaginable—one can always posit higher tariffs—but it is the worst that has a basis in recent rhetoric.

Such a scenario would have a meaningful impact on the U.S. economy. Canada’s 15% average tariff would put U.S. industries at a material disadvantage north of the border. Sectors with significant exports to Canada, narrow margins, and foreign competitors could struggle. Northern states, many of which count Canada as their number one export market, would slow. But even in the most-affected U.S. sectors and regions, reliance on trade with Canada is small compared to the other way around. In the most exposed U.S. industries, less than 10% of sales go north, while in the most vulnerable states, exports to Canada generally account for less than 5% of GDP.

However, larger U.S. tariffs would also undermine domestic purchasing power, lifting prices by perhaps 1% over time. All together, the impact on real consumer spending, investment, and trade could eventually lower economic activity by around 1% relative to pre-tariff trends. On its own, such a scenario would yield slower, but not negative U.S. growth. However, the impact would add to other trade headwinds. Rising prices and a deteriorating labour market would present the Fed with an uncomfortable dilemma. Unless confronted with signs that higher inflation was becoming entrenched, it would likely act more quickly to lower rates to neutral territory, or somewhat below.

In Canada, a recession would be virtually assured. A 35% tariff in the U.S. market would leave Canadian products at an enormous disadvantage to both U.S. and overseas competitors and would be too large to absorb into profit margins. Exports would plunge, and so too would business investment. Although lower imports would lessen the pressure on net trade, the decline would mainly reflect weakening domestic demand. Bank of Canada easing would help stanch the damage, but its response would be constrained by concern about inflation. The policy rate would likely be cut well into stimulative territory, but not to the lower bound, perhaps bottoming around 1%.

In the first year or so, real GDP in Canada would decline perhaps 1%-to-2%. The unemployment rate would jump by 1.0-to-1.5 percentage points, reflecting major job losses in industries reliant on U.S. trade and cascading effects across the rest of the economy. Over time, economic activity would likely end up around 5% below pre-tariff growth trends. With the economy in recession and interest rates in decline, the Canadian dollar could lose perhaps 10% of its value, which would partly offset the U.S. tariff and would give Canadians another reason to buy domestic. However, it would also weigh further on domestic purchasing power. Over time, the price level could rise perhaps 4%. The government would almost certainly respond with stimulative fiscal policy, which would help buoy economic activity but would also worsen pressure on prices. Canada would seek deeper economic ties elsewhere, but they would take time to establish, and trade would be costlier over long distances.

Markets would react to all of this in short order. Equities would decline and corporate spreads would widen, perhaps significantly. Canadian assets would naturally be hardest hit, but U.S. markets could also struggle given elevated starting valuations, tensions with other trading partners, and broader concerns about economic and fiscal policy. The market downturn would be caused by, and then ultimately contribute to, the adverse economic outcome. Long-term government bond yields would probably decline moderately, as occurred earlier this year, provided that inflation expectations remain anchored.

Such an outcome would provoke deep structural change across the North American economy, much of which would only be felt over the long term. In Canada, firms would be reluctant to strand fixed assets but would likely favour the U.S. for new investment. Productivity, already struggling, would remain under pressure. The U.S. would likely see some individual victories on investment, but it would ultimately be worse off with a more compartmentalized North American economy.

Bottom Line: The stakes are far from even, but the U.S. and Canada both have plenty to gain from a swift and smooth renewal of the USMCA and a return to productive cross-border cooperation.