North American Outlook

September 02, 2025 | 13:29

The Trade War And The Damage Done

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

Casualties of the trade war are showing up on both sides of the U.S.-Canada border, though the outlook has improved somewhat.
Despite deals with some major U.S. trading partners, the trade war endgame is unclear, as deals with Canada, Mexico and China remain elusive.
Tariffs, deportations, and DOGE have slowed U.S. activity, though expansionary fiscal policies and lower interest rates will provide support.
As expected, Canada's economy contracted in the second quarter. While it may avoid a technical recession, downside risks will persist until the USMCA is re-signed.
Central banks on both sides of the border will look past tariff-led price increases and resume rate cuts this fall.

Trade War Endgame in Sight?

Several trading partners, including the European Union, Japan, South Korea, and the U.K., managed to reach deal frameworks with the White House before its self-imposed August 1 deadline. Apart from the UK's 10% duty, the other regions were hit with levies ranging between 15% and 20%. They also pledged hundreds of billions of dollars in direct U.S. investments and purchases of American-made goods. Over 60 other countries were slapped with modified reciprocal duties ranging between 15% and 41%, while Brazil and India were hit with 50% levies. Trading partners that run deficits with the U.S. will face a lighter 10% duty. The U.S. still needs to make deals with Canada, Mexico and China. The latter two countries were granted formal 90-day extensions, though Canadian and U.S. officials continue to talk.

Of course, none of the tariffs are written in stone. A federal appeals court recently ruled that most of the levies are illegal, though they will remain in place until October 14 to give time to file an appeal in the Supreme Court. If needed, the Administration could impose duties under other trade acts.

More sectoral duties are also in the works. The White House recently imposed 50% duties on select copper products, and investigations are underway for eight other industries, including lumber, aircraft, microchips, and medicines.

The big picture is that the trade war seems to be converging on a new normal, one of higher but manageable tariffs, which businesses and consumers will need to adapt to.

United States

Economic weakness first evident in surveys is now showing up in harder data. Private nonfarm payroll gains averaged just 80,000 in the five months to July, the second-weakest pace (apart from the pandemic) since 2010. Without increases in health care, job growth would have ground to a near halt. This is less a reflection of outright layoffs and more due to subdued hiring amid uncertainty related to trade policies and AI adoption. Consequently, long-term joblessness is now the highest (outside the pandemic) since 2017. While the unemployment rate is little changed at 4.2% in the past year and close to full employment, it’s been subdued by slower labour force growth amid an immigration crackdown.

Looking past wide swings in imports and inventories in the first half of the year—as businesses tried to avoid the first wave of tariffs—it’s clear that the economy’s underlying pace has slowed. Real GDP growth averaged 1.4% annualized in the first two quarters, the weakest rate in three years. Not helping matters is that 30-year mortgage rates are still above 6 1/2%, keeping existing home sales pinned to 14-year lows, and causing prices to sag in parts of the country. On a more positive note, however, business investment picked up in the first half of the year, and not just because of tariff front-running. Corporate earnings are rising steadily, businesses are spending heavily to develop and adopt AI, and tariffs are leading to some reshoring of manufacturing. The federal government’s business-friendly policies, including lighter regulation and accelerated depreciation allowances on investments, are also providing support.

Modest growth will likely persist in the second half of 2025. With the U.S. average effective tariff rate at around 18% (a seven-fold rise from last year), economic growth is expected to be at least one-half percentage point slower this year as a result. Import taxes could generate nearly $400 billion in annual revenue for the government, but at the expense of slower domestic demand. To date, businesses have been reluctant to fully pass tariffs onto customers for fear of losing market share; yet, companies can’t absorb big losses indefinitely. (GM and Ford both reported near billion-dollar quarterly hits to earnings.) Annual CPI inflation, at 2.7% in July, will likely pop above 3% later this year. Adding to the growth drag will be deportations, higher student loan payments, and the legacy of the DOGE-led cuts to the federal government. Still, stronger consumer spending and capital goods orders in July suggest some resiliency in the economy. All in, we project GDP growth of 1.7% in 2025, down from 2.8% last year. The jobless rate is expected to rise moderately to 4.6% by year-end, which, in turn, should ensure that the inflationary impact of tariffs is temporary.

Assuming trade-related uncertainty ebbs, economic growth should improve in 2026. The One Big Beautiful Bill Act will reduce personal income taxes and offer tax breaks on overtime pay and tips. Federal spending will also increase for defense and border control, though funding will decline for health care, student loans, and food stamps.

Monetary policy is also poised to lift the economy. After cutting rates by 100 bps last year, the Fed has retained a moderately restrictive policy stance due to “somewhat elevated” inflation and uncertain trade policies. However, Chair Powell recently opened the door for a September 17 rate cut by highlighting downside employment risks, while downplaying inflation risks from tariffs. With a potentially more dovish Fed Chair taking the helm in May 2026, policy rates are expected to decline by 150 bps to below 3.0% before year-end 2026.

Canada

Rather than a formal extension of trade talks, Canada was slapped with a higher 35% “fentanyl” duty (up from 25%). Still, the average effective tariff rate on goods exports to the U.S. rose only slightly to around 7%. This is because, apart from steel, aluminum and some copper products (all facing 50% duties) and motor vehicles (25%, though roughly halved by the U.S. content carve-out), over 90% of goods exports are shipped duty free under the exemption for USMCA compliancy. But the pressure is on Canada to renegotiate the free-trade agreement when the formal review comes up in July 2026, with talks expected to begin sooner. If the U.S. were to walk away from the USMCA after giving six months’ notice, Canada’s economy could face a deep downturn.

To little surprise, real GDP contracted 1.6% annualized in Q2 amid pandemic-like drops in exports and business equipment investment. Basically, the trade war put an abrupt end to an expansion that was outrunning most other advanced nations, including the U.S. Still, we now expect the economy to avoid a 'technical' recession and expand slightly in Q3. Consumers are showing some resiliency, with real spending up 4.5% annualized in Q2 and auto sales revving higher in July. Providing support are record equity values, positive income growth, and lower borrowing costs. The latter has pulled debt service costs down from record highs, easing the pain of mortgage resets. Although joblessness is on the rise, this largely reflects earlier rapid population growth, which has since cooled. While job growth has slowed to an average of 15,000 per month this year, about half last year's rate, most workers continue to draw a paycheque. Further support stems from the “Buy Canada” movement and a recent upturn in international tourism amid stricter U.S. border controls.

The economy should strengthen to a 1.4% rate in 2026 from an estimated 1.2% in 2025, with help from lower interest rates, federal financial support for tariff-affected industries, and increased federal spending on housing, infrastructure, and defence. Initiatives to fast-track energy and mining projects and eliminate provincial trade barriers will also help, as will a trim to personal income taxes. The unemployment rate, currently at 6.9%, looks to peak at 7.3% by year-end, before falling to 6.7% late next year.

Despite slower population growth, home sales are turning around after struggling for three years. Still, market conditions vary widely by region. Buyers continue to call the shots in Ontario and B.C., dragging prices lower; while sellers remain in command across the Prairies, Atlantic Canada, and Quebec, sending values higher (notably in Quebec City, up a sizzling 18% y/y in July). Sales should get a mild lift when the federal government passes legislation to reduce the GST on new homes for first-time buyers.

Consumer inflation remains low at 1.7% y/y in July, partly due to the removal of the consumer carbon tax. But the central bank believes the underlying rate is still tracking moderately above the target. Even so, we expect inflation to average around 2.0% this year and next, as rising slack in the labour market counters a modest lift from retaliatory tariffs (which were recently scaled back again to support trade talks).

Stubborn core inflation sets a high bar for another Bank of Canada rate cut, reducing the odds of a move on September 17. However, if future job and inflation reports are subdued, the Bank could ease in October, eventually taking the policy rate down 75 bps to modestly stimulative levels of 2.0% before next spring.

If the Fed reduces rates faster than the Bank of Canada next year, and assuming no major trade stumbles, the Canadian dollar could strengthen modestly from under 73 cents US recently to 75 cents by late 2026.