North American Outlook

August 08, 2025 | 11:33

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.
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 undercut U.S. employment and consumption, though expansionary fiscal policies and lower interest rates will provide support.
Canada's economy likely contracted last quarter and, while it may skirt a technical recession, faces material downside risks until trade tensions subside.
As casualties mount, Generals Powell and Macklem will look past tariff-led price hikes and ride to the economy's defence.

Trade War Endgame in Sight?

Six trading partners, including biggies 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 (how their governments will compel private businesses to fulfill these pledges isn't clear). Over 60 other countries were slapped with modified reciprocal duties ranging between 15% and 41%, while other trading partners (including those that run trade deficits with the U.S.) face a minimum 10% base duty.

Of course, none of the tariffs are written in stone and all could change on a whim. Moreover, the U.S. Court of Appeals may rule the tariffs illegal, though the Administration could try to secure a favorable ruling in the Supreme Court or impose duties under a number of other trade acts. Importantly, the U.S. still needs to make deals with three major trading partners: Canada (which remains in limbo), Mexico (which was granted a 90-day extension), and China (with an August 12 deadline looming). Meanwhile, the White House has just imposed 50% duties on select copper products, with investigations underway for eight other industries, including lumber, microchips, and medicines. The big picture is that we are likely only in the middle stages of this battle, with more surprises to come. Businesses hoping for clarity before committing to hiring and investment decisions will need to wait longer.

United States

Despite the fact that some import taxes—running in the hundreds of billions of dollars on an annual basis—will be paid by U.S. importers and consumers, the Administration deemed the deals a win. So, it's somewhat ironic that in the same week that it announced modified reciprocal duties, possible signs of harm from the trade war emerged in employment and personal spending. The fraying first seen in the so-called soft data is now showing up in the hard data.

Private nonfarm payroll gains averaged 80,000 in the past five months, the second-weakest pace (apart from the pandemic) since 2010. And, barring strong hiring in health care and social assistance, job growth would almost have ground to a halt. While the unemployment rate is little changed at 4.2% in the past year—essentially "full employment"—it’s been subdued by slower labour force growth due to the immigration crackdown. Weakening demand for and supply of workers is a symptom of a soft labour market. The former is less a reflection of outright layoffs, which are about normal following earlier cuts to the federal workforce, and more due to stagnant hiring, which businesses say partly reflects chaotic trade policies but also the adoption of AI systems. Consequently, long-term joblessness is now the highest (outside the pandemic) since 2017.

The impact of weaker job growth is showing up in the consumer spending data. Tariff-led price increases for some items, such as appliances and computing gear, might also explain a recent sag in durable goods demand. This is despite improved consumer confidence stemming from the high-flying equity market.

In fact, looking through the wild 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 1.2% annualized in the first two quarters, while combined consumer/business expenditures slowed to a similar pace in Q2, the weakest in three years. Not helping matters is that 30-year mortgage rates are still near 7%, keeping existing home sales pinned to 14-year lows, and causing prices to sag in some regions, including Florida and Texas.

Modest growth will likely persist in the second half of 2025. With the U.S. average effective tariff rate at around 18%, compared with just over 2% last year, economic growth is expected to be nearly 1 ppt lower this year than would otherwise be the case. This level of 'taxation' could generate nearly $400 billion in annual revenue for the government, but the cost will be partly borne by consumers. To date, businesses have been reluctant to fully pass the tariff bill onto customers for fear of losing market share (GM and Ford both reported near billion-dollar quarterly hits to earnings). Yet, companies can’t absorb big losses forever, especially now that new tariffs look to remain in place. Adding to the growth drag will be deportations, higher student loan payments for millions of borrowers, and the legacy of the DOGE cuts. All in, we project GDP growth of 1.5% this year, or about half of last year’s rate and somewhat below long-run potential.

Assuming trade tensions ease, economic growth should improve in 2026. A reduction in trade-related uncertainty could unleash delayed investments, fanned further by deregulation and the full and immediate expensing allowance provided in the One Big Beautiful Bill Act. Businesses are spending hundreds of billions of dollars to build AI infrastructure, including massive data centers, and adopt AI systems in factories and offices. Investment in information-processing gear contributed 0.6 ppts to annualized real GDP growth in the first half of the year, providing half of overall growth. In time, the AI payoff will be rising productivity, albeit at the cost of significant job displacement. For consumers, lower personal income taxes and tax breaks on overtime pay and tips will provide support. Federal spending will also increase for defense and border control, though funding will decline for health care, student loans, and food stamps. A budget deficit of around 7% of GDP, unheard of outside of wars, recessions and pandemics, cannot not provide an economic lift.

Monetary policy is also poised to lift the economy. After cutting rates by one percentage point last year, the Fed has retained a moderately restrictive policy stance due to “somewhat elevated” inflation, solid economic growth (until recently), and uncertain trade policies. Chair Powell’s post-meeting remarks showed little urgency to resume easing. Still, should the jobless rate climb further in August—and then toward 4.6% later this year, as we suspect—the Fed will feel compelled to look past a one-off tariff-led spike in inflation and resume rate cuts in September. Additional moves should pull the fed funds rate below 3% and into mildly stimulative territory by the end of 2026.

Canada

Despite weeks of high-level trade talks, Canada was slapped with a 35% “fentanyl” duty (up from 25%), while receiving no break on sectoral tariffs. Still, the average effective tariff rate on goods exports to the U.S. rose just slightly to around 7%, as only a small share (likely less than 10%) is not compliant with the USMCA. Apart from steel and aluminum (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. That's why the pressure is on Canada to renegotiate the free-trade agreement when the formal review comes up in July 2026, though talks are expected to begin sooner. If the U.S. were to walk away from the deal after providing six months’ notice, Canada’s economy could face a deep downturn.

Even under a manageable tariff regime, the economy likely contracted modestly in Q2 due to plunging exports of steel, aluminum, and automobiles to the U.S. and deferred business investments. This could mean an abrupt end to an expansion that was outrunning most other advanced nations, with real GDP up 2.3% y/y in Q1.

Still, we now think the economy may avoid a 'technical' recession by holding flat in Q3 and growing 1.5% annualized in Q4. Consumers are showing some resiliency, with advance retail sales rebounding smartly in June 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, while easing the pain of mortgage resets. Although joblessness is on the rise, this largely reflects earlier rapid population growth, which has since cooled. Most workers are still drawing a paycheque, even as job growth has slowed to an average of 15,000 per month this year, about half last year's rate. 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 in 2026 with help from lower interest rates, increased federal spending on infrastructure, housing, and the military, and financial support for tariff-affected industries. Initiatives to fast-track energy and mining projects and eliminate provincial trade barriers will provide additional support, as will a trim to personal income taxes. In all, real GDP is expected to grow 1.3% in 2025 and 1.4% in 2026, modestly below potential and last year's rate. The unemployment rate, currently at 6.9%, looks to peak only moderately higher at 7.3% at year-end, before falling to 6.7% late next year.

Despite slower population growth, home sales have turned the corner after struggling for three years. Still, market conditions vary widely by region. Buyers 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 16% y/y in June). Sales should get a modest fillip when the federal government passes legislation to reduce the GST on new homes for first-time buyers.

Consumer inflation remains low at 1.9% y/y, partly due to the removal of the consumer carbon tax. But the central bank believes the underlying rate is tracking higher at around 2.5%. Even so, we expect inflation to average around 2.0% this year and next, as rising unemployment should counter the effect of limited retaliatory tariffs. Labour market slack is evident in the lowest job vacancy rate in eight years.

Stubborn core inflation sets a high bar for another Bank of Canada rate cut. However, we see it coming off the sidelines this fall if the next jobs report and CPI releases are subdued. Cumulative cuts of 75 bps should take the policy rate down to a modestly stimulative level of 2.0% by March 2026.

Should the Fed ease more than the Bank next year, and assuming no major trade stumbles, the Canadian dollar might rise modestly from under 73 cents US recently to 75 cents by late 2026.