North American Outlook

October 07, 2025 | 08:28

Resilience and Recovery

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

As economies adjust to a somewhat calmer trade battlefield, Canada and the U.S. are showing signs of resilience and even recovery.
Both economies will get a boost from expansionary fiscal policies, renewed monetary policy easing, and looser financial conditions
Risks stem from somewhat sticky inflation, a possible prolonged partial shutdown of the U.S. government, and an escalation of the trade war pending USMCA renegotiations.

United States

Tariffs have caused some 'stag' and a little 'flation', but less of both than feared. Make no mistake, growth has slowed this year. Real GDP grew at an average annualized rate of 1.6% in the first half, down from 2.8% in 2024. Consumer spending averaged just 1.5%, half of last year's rate. Still, overall growth remains near the economy's long-run potential rate of about 1.8%. Private domestic demand has provided the backbone by advancing 2.4%, led by business fixed investment. Technology companies are spending massive sums to build AI infrastructure, notably data centers, while other firms are investing heavily to adopt AI systems.

Even after rebounding 3.8% annualized in the second quarter, real GDP has a good wind at its back. With personal spending likely accelerating to over 3% in the third quarter, we lifted our GDP growth call to 2.8%. This puts the economy on track for near-2% growth for all of 2025, a major improvement from the darkest days of the trade war in early April ("Liberation Day"). Propelling consumers (at least upper-income ones) is a powerful wealth effect from record-breaking equity markets.

Aside from ongoing federal government cutbacks, there are two soft spots in the U.S. economy. The first is the housing market, where activity has struggled ever since the Fed began tightening policy in 2022, driving mortgage rates to multi-decade highs. However, a recent easing in borrowing costs appears to be putting a floor under the market.

The second, and more worrisome, source of weakness is the labour market. Nonfarm payroll gains averaged just 64,000 in the six months to August, about a third of the rate in the previous half year. This is partly due to still-elevated interest rates and uncertain trade policies. But it also stems from two other forces: deportations, which are slowing growth in the workforce, and AI, which is making some managers think twice about hiring. Walmart's CEO is the latest high-profile executive to sound the alarm. The country's largest private employer plans to keep staff levels flat over the next three years as AI eliminates and transforms "literally every job". This effectively serves as a warning for other retailers to remain competitive.

For these reasons, the Fed now believes downside employment risks outweigh upside inflation threats stemming from tariffs. As a result, the FOMC resumed lowering policy rates for the first time this year in September. With the federal funds target rate still modestly restrictive at just above 4%, there's more easing to come, even if services inflation remains elevated. We expect follow-up moves in October and December, and a combined 125 bps of rate relief over the next year.

Apart from an escalation of the trade war, the biggest risk to the U.S. expansion stems from a potential prolonged partial shutdown of the federal government. Should the closures last five weeks, as per the last one in 2018-19, it would slow the expansion only moderately, reducing Q4 annualized growth by about one-half to one percentage points. But if it lasts a few months, GDP could contract. Congress would likely then pass a continuing resolution to restore funding, and the flood of repayments to federal workers would support a return to positive growth.

Canada

The worst may be over for Canada's economy. After contracting in the second quarter due to pandemic-like declines in goods exports and machinery investment, real GDP turned modestly higher in July, putting growth on track to meet, and possibly exceed, our current estimate of 0.5% annualized in Q3. Barring an escalation of the trade war, both exports and investment spending look to stabilize soon. With plenty of fiscal stimulus in the works (details in the November 4 Federal Budget), and the central bank on an easing path, the economy should gather steam in the coming quarters.

Although new U.S. tariffs have been announced for the softwood lumber, furniture, pharmaceuticals (brand name only), and heavy truck industries, they are not expected to raise the average effective tariff rate on Canadian imports above 7%, which is manageable. As a result, we have kept our economic forecast unchanged.

Households are doing their utmost to cushion the blow from the trade war. After nearly stalling earlier this year due to economic concerns, consumer spending rebounded almost 5% annualized in Q2. Moreover, retail sales appear to have advanced further this summer. With Canadian southbound visits down 31% this year, billions of dollars have been redirected toward domestic tourism, which accounts for over 1% of GDP. A sizzling TSX is also greasing the spending wheels.

As in the U.S., Canada's housing and labour markets are a couple of weak links in the economic chain. While national existing home sales have risen for five straight months to August, demand remains weak in Ontario, the province at the epicenter of the correction. However, improving affordability amid sagging prices should lead to some near-term stability in Ontario's sales and a modest recovery next year. Meanwhile, large job losses (a net -106,000 or -0.5%) in July and August, even outside the three tariff-hit industries (steel, aluminum, and autos), are concerning given potential knock-on effects to spending. Still, with the economy expected to improve on more stimulative policies, the current 7.1% unemployment rate should rise only slightly further, before declining somewhat next year.

The deep job losses have caught the Bank of Canada's attention. Despite underlying inflation still hovering moderately above the 2.0% target, the Bank resumed lowering policy rates to 2.50% in September. While it may hold off on a follow-up move later this month to better assess trends in the labour market and inflation, rate cuts are expected in December and March. That should bring the policy rate to 2.0%, or zero in real terms, and modestly stimulative for the economy.

The biggest risk facing Canada is if the U.S. Government walks away from the USMCA (after six months notice), causing exporters to lose the compliance exemption. In this event, the economy would likely face a recession. Consultations between the U.S. government and businesses have begun and hopefully will underscore that re-signing the free trade agreement, even with modifications, is in the best interests of all three countries.