North American Outlook

February 05, 2025 | 11:52

Tariff Reprieve

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

Canada's economy will either improve this year or slide into a moderate recession—it all depends on which way the tariff winds blow. We assume the former, but fear the latter.
U.S. economic growth should remain decent this year, even as it downshifts a little from last year's strong pace or somewhat more under a limited trade war.
The Fed will walk the sidelines for the next few meetings given the hazy trade and inflation climate, while the Bank of Canada likely has a couple more rate cuts under its belt.

We are purposely keeping this economic update shorter than usual due to its tenuous shelf life. How tenuous? In the span of 48 hours we went from projecting a decent upswing in Canadian economic growth after two years of sogginess, to foreseeing a moderate recession, to ultimately making just a modest downgrade to our original outlook. The swing factor, of course, was the U.S. executive order of February 1 that slapped 25% tariffs on imports from Canada (10% on energy products); followed, two days later, by a decision to delay the duties for 30 days. Assuming continued progress toward resolving border, drug and other 'national emergency' issues, thereby extending the tariff reprieve, the next big hurdle for Canada is on April 1, when the U.S. could start applying broad tariffs on countries deemed to pose a national security risk or have an unfair trade advantage over American businesses.

Under the assumption that Canada avoids a trade war, its economy should pick up to a 1.7% annual rate this year from an estimated 1.3% in 2024, and improve somewhat further next year. Falling interest rates are already supporting consumer spending, notably for autos. While most households are still refinancing mortgages at much higher rates than several years ago, they are doing so at a much lower cost than once feared, after a more than 1-ppt decline in fixed rates and 2-ppt slide in variable rates. Moreover, the Bank of Canada is expected to lower policy rates another 50 bps by the summer, as CPI inflation looks to hover near the 2% target. This, and the previous 200 bps of cuts, should encourage a further gradual recovery in housing markets, despite some drag from immigration curbs. Meantime, exports will find support from a low loonie that is unlikely to rise above 72 cents US this year, with the tariff sword hanging over its head and gaping rate spreads with the U.S. widening further. New LNG Canada shipments starting mid-year will also bolster exports. The main laggard will be business investment, which will struggle to advance after shrinking last year. According to a KPMG survey, many firms plan to shift some production across the border to avoid the intense trade uncertainty. As a result, our GDP growth call this year is 0.2 ppts lighter than previously expected. With the economy growing close to potential, the jobless rate will likely peak around 7% this spring, before easing to 6.6% next year.

Should tariffs be imposed and remain in place for a full year, Canada, and especially manufacturing-heavy Ontario and Quebec, would likely face a recession that sends the national jobless rate up one percentage point to around 8%. The slow recovery in the housing market could be prolonged with prices falling somewhat further in a few regions. The economy would recover after the tariffs are lifted (or adjusts to the new framework), but only slowly given sluggish business investment. You can read the grim details here.

With a smaller export sector and larger services sector, the U.S. economy would suffer far less than Canada in a limited trade war. After the initial tariff announcement on February 1, we trimmed our 2025 U.S. growth outlook by less than half a percentage point to a still-decent 2.1%. However, the effects would accumulate if more countries were drawn into the battle, as is possible on April 1. That's when the America First Trade Policy memorandum's requested reports could recommend broader tariffs for reasons of national security or unfair trade practices.

We reverted to our previous outlook for the U.S. economy following the 30-day pause announced on February 3. China's limited counter tariffs, so far, should have little effect. After growing 2.8% in 2024 on strength in consumer spending and sturdy gains in government and business spending, U.S. real GDP growth is expected to stay healthy at 2.4% in 2025. Lower interest rates and the administration's pro-business policies, notably lighter regulation and potential corporate tax cuts, will provide support. However, tax cuts could be delayed given the administration's current focus on trade protectionism and shrinking the government, both of which could impede activity initially. Still, consumers just had their best quarter in nearly two years, supported by healthy job and income growth. Wage gains have moderated but are outrunning inflation. The current low unemployment rate of 4.1% in December is expected to edge up only slightly in the months ahead.

Housing is the one soft spot in the U.S. economy due to a lack of affordability and availability. The former is near the worst levels in four decades due to a recent backup in mortgage rates and rising home prices (and tariffs on imported building materials wouldn't help). Existing home sales remain close to 14-year lows and are expected to recover only slowly as interest rates fall.

After trending lower, inflation appears to have stalled above the 2% target. For that reason, and the uncertain trade policies, the Fed decided to pass on reducing policy rates on January 29. Barring material tariffs, we expect inflation to decline gradually, allowing the Fed to resume easing policy in June, lowering rates three times this year and twice next year for a total reduction of 125 bps.