North American Outlook

July 30, 2026 | 16:23

Iran and Trade Wars: Season 2, Episode 11

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

Just as we were lifting our growth outlooks for the U.S. and Canada, the outlook has taken a darker turn, particularly in Canada, amid an escalation in both the Iran and U.S. trade wars.
Higher fuel costs and new tariffs raise the risk of Fed tightening, though we expect policymakers to remain patient so long as core inflation retreats.
A weaker economy, lower core inflation, and new trade risks should dissuade the Bank of Canada from raising rates.

United States

Renewed U.S. and Iran military attacks have shut the Strait of Hormuz once again, while Houthi attacks in the Red Sea threaten to disrupt another critical shipping route for global energy and supplies. Consequently, U.S. oil prices have rebounded from close to pre-war levels of $67 to over $80, while gasoline prices have been even firmer. Although American consumers have managed to maintain spending despite higher fuel costs, the latest surge could prove damaging in another way: by keeping inflation elevated and pushing the Fed to tighten policy. The benchmark 10-year Treasury yield has risen to 18-month highs above 4.6%, lifting mortgage rates and dashing hopes of a housing recovery.

Prior to the latest flare-up in the Middle East, stronger economic data and a benign June CPI report had brightened the U.S. outlook, spurring a modest upgrade to our forecast while reducing the risk of Fed tightening. Despite softer-than-expected real GDP growth of 1.5% annualized in Q2, which was largely due to increased imports and declining business inventories and federal spending, underlying economic activity remained solid. Real final sales to private domestic purchasers rose 3.9%, the most in over three years. Consumer spending growth accelerated to 3.2%, while nonresidential business investment grew 8.4%, led by a 15% surge in equipment spending. Real investment in computer hardware, software and data centre construction slowed to 18% y/y in Q2 from 25% in Q1, but still added an estimated 0.6 ppts to GDP growth (of 2.1%) in the past year. However, surging imports of computer hardware cut the net contribution roughly in half. For all of 2026, growth looks to remain steady at 2.1%, just above long-run potential.

With the workforce shrinking due to deportations and reduced immigration, labour productivity growth has become the sole driver of the economy’s supply-side expansion. It rose 2.8% y/y in Q1, almost a percentage point faster than the quarter-century average. This is also helping to contain inflation, by reducing unit labour cost growth to just 0.5% y/y, a seven-year low. So, inflation should recede once the effects of tariffs and higher fuel costs fade.

Alas, both are moving in the wrong direction. The U.S. recently imposed new duties on Brazil, threatened a hefty 50% levy on some of Canada’s exports (starting August 19), and recently replaced the expired Section 122 tariffs with the first tranche of more legally-defensible Section 301 duties, thereby keeping the average U.S. tariff rate above 11%. This won't make the Fed's job of restoring price stability any easier.

As expected, the FOMC stood pat on July 29, despite repeated pledges to restore price stability, though three members dissented in favor of tightening. The futures market still sees one Fed rate hike by year-end, suspecting that more policymakers will lose patience with inflation hanging above the target for five years. However, we still expect the Fed to remain patient so long as core inflation shows steady progress toward the target. The core PCE rate edged down to 3.3% in June. In fact, it could decline modestly further in August simply due to new methodology changes that will reduce measured price increases in software and portfolio management fees. We expect the core rate to slip into the low-2% range by spring 2027, assuming the effects of higher energy costs and tariffs fade. This could pave the way for two quarter-point rate cuts later that year, shifting policy from a mildly restrictive stance to a more neutral setting.

Canada

Prior to July 20, the clouds hanging over Canada’s economy were beginning to part. A hiring rebound had recouped all but 6,300 of the 112,300 jobs that were lost in the first four months of the year. And, after contracting for two straight quarters, real GDP appears to have rebounded by around 2% annualized in the second quarter, amid a pickup in retail sales, manufacturing shipments, and home sales. The rebound has quieted recession talk and supports our forecast for a return to above-potential growth of 2.0% in 2027.

However, the outlook darkened after the U.S. administration announced 50% duties on about 5% of Canada’s goods exports to the U.S. (representing 0.8% of GDP) under the never-used-before Section 338 of the Tariff Act of 1930 (yes, Smoot-Hawley). The threat of tariffs on a slice of goods that were previously exempt under the USMCA marks a significant escalation in trade tensions, one that risks undermining business confidence and investment even further. While Canada's average tariff rate on exports to the U.S. would rise only moderately, from 5.0% to around 7.5%, the industry-specific effects could be severe and spread far beyond the already-damaged steel, aluminum, lumber, and auto industries. At elevated risk are electronics, plastics, chemicals, wood products, alcohol, and clothing. Regionally, British Columbia, Quebec and Ontario look to bear the most pain, with the latter two provinces already taking the brunt of the heavy metal and auto duties. Overall, we estimate that the Section 338 tariffs could reduce annual real GDP growth by roughly one-half percentage point and raise the unemployment rate by two tenths. Thankfully, they do not take effect until August 19, allowing time for talks to repeal the duties. The hope is that they are more a negotiating tactic in current USMCA discussions than a fundamental shift in trade policy. For this reason, we have not yet lowered our growth outlook.

For the Bank of Canada, just when it seemed that the economy was beginning to adapt to the trade war, any budding momentum risks being zapped by new tariffs and trade policy uncertainty. This threat, coupled with some slack in the economy and resulting benign inflation—most core CPI measures are running at or below the 2% target—should keep the central bank firmly planted on the sidelines. We continue to expect no rate moves in either direction through next year, even as the market anticipates one rate hike by year-end. In fact, a major escalation of the trade war could push the Bank to lower rates to support the economy.