North American Outlook

March 16, 2026 | 10:28

From Trade Pot To Oil Frying Pan

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

The Iran war will lead to higher inflation but, barring a prolonged disruption to global energy supplies, just a moderate reduction in economic growth in North America.
The Fed will likely wait longer before trimming rates, while the elevated uncertainty will prolong the Bank of Canada's stay on the sidelines.

The conflict with Iran means the U.S. and Canadian economies are facing their second stagflation-like shock in a year. On the heels of last year's trade war, the Iran conflict's impact on energy prices will lift inflation and bond yields and weaken global demand, confidence, and equity markets. All five channels will undercut economic growth, while handcuffing central bankers from providing support. However, compared with previous oil price shocks, economies are less energy-intensive, while the U.S. has become a (modest) net exporter of energy products and Canada a significant one.

The war's economic impact largely hinges on where energy prices settle, especially oil. Within the first two weeks of the conflict, U.S. oil prices surged from $67 a barrel to nearly $120 before slipping below $100 on March 16. Based on a weighted average of some plausible scenarios, we expect prices to average above $90 in March and April before moving under $70 by year-end and averaging $75 this year, or 25% higher than in our previous outlook. This assumes the conflict causes no serious damage to the Persian Gulf oil infrastructure or prolonged blockage of the Strait of Hormuz.

United States

Higher oil prices are expected to lift CPI inflation from 2.4% y/y in February to a peak of 3.6% this spring, before retreating below 3% by year-end. The 2026 average of 3.0% would mark a 0.6-ppt upgrade from our previous view. With energy a key driver of business input costs, even core inflation will nudge higher. And, this is at a time when the Fed's preferred measure of underlying inflation, core PCE prices, is already running hot, at 3.1% y/y in January, up from a cycle-low of 2.6% last April before reciprocal tariffs kicked in. Core PCE inflation could average 2.9% in 2026, marking a sixth straight year above the target. That's not exactly what the Fed had in mind when it was considering 'average inflation targeting' back in 2021.

Higher fuel and other costs will erode buying power, especially for lower-income households. This is the main reason we reduced our real GDP growth forecast by 0.3 ppts to 2.2% in 2026. That said, this is still a step up from last year's pace of 2.1% and long-run potential growth of around 2%. Sturdy AI-driven business investment and stimulative fiscal, regulatory, and monetary policies should mostly counter the effects of the Iran war. Alphabet, Amazon, Meta, and Microsoft alone plan to spend more than half a trillion dollars this year, largely on data centres to power AI systems. Of course, this all assumes a manageable rise in oil prices. A sustained move above $140 a barrel could be the tipping point for recession.

Meanwhile, the trade war remains an ongoing risk. New 10% duties have already been imposed to replace about half of the now-illegal international emergency levies. However, the aim is to buy time for the White House to impose more permanent duties under other trade statutes that will fully replace the IEEPA tariffs. We assume the renegotiation of the USMCA will extend beyond this year. Although Canada and Mexico have more to lose should the U.S. withdraw from the Agreement, the U.S. economy would still slow amid the disruption to supply chains and rise in tariffs. We also assume the U.S. will extend a one-year trade truce with China later this year, averting higher tariffs.

The U.S. economy's resilience, unfortunately, is not generating many new jobs. Companies are controlling costs by improving efficiencies, with annual labour productivity growth trending above 2%. Nonfarm payroll gains averaged just 6,000 in the three months to February, and employment would have contracted if not for brisk hiring in healthcare and social assistance. Given deportations and immigration restrictions, the break-even rate for monthly job growth might have fallen to 30,000-50,000 from the longer-run range of 160,000-180,000. This will at least temper further increases in the unemployment rate, currently at 4.4%.

Rising oil prices present a major dilemma for the Fed. While a weak labour market argues for renewed rate cuts, sturdy economic growth alongside rising inflation will demand patience. At a minimum, the policy-setting committee will wait to see if inflation expectations have become unmoored. As a result, we no longer expect a June rate cut and see just two reductions, in September and December, instead of three previously. This will bring the federal funds rate close to the midpoint of the FOMC's neutral range (3.0%) by year-end.

Canada

The inflationary impact of rising oil prices on Canada is similar to that in the U.S. and will likely lift CPI inflation from 1.8% in February to an average of 2.9% in 2026. The growth hit is also broadly comparable. While Canada's economy is more exposed to weaker global demand than that of the U.S., it is also more leveraged to higher energy prices. Goods exports account for nearly a quarter of Canada's GDP, versus 7% in the U.S., while the trade surplus in oil and natural gas products represents 4% of GDP, compared with a negligible 0.1% in the U.S. We lowered our real GDP growth forecast by 0.3 ppts to 1.0% in 2026, with expansionary fiscal policies providing some offsetting support. Heavy oil producers Alberta and Saskatchewan should lead the country in growth once again this year, while energy-consuming Central Canada will continue to lag amid ongoing trade-policy uncertainty.

Even before the Iran war, Canada's economy was on the defensive. Real GDP contracted slightly in Q4, though wholly due to a sharp drop in inventories. Most sectors expanded at a healthy rate, including exports and consumer spending, while governments spent freely on defence and infrastructure. Even business investment advanced for the first time in a year, led by the biggest increase in spending on computer equipment since 1991. An upturn in advance retail sales in January suggests the economy returned to positive growth in Q1, but only slightly amid declines in exports, wholesale trade, and factory shipments. Of more concern, employment plunged by 109,000 in the first two months of the year and has barely grown in the past year. The current unemployment rate of 6.7% will likely represent the 2026 average, down slightly from last year largely because immigration curbs are shrinking the labour force.

A more meaningful economic rebound likely awaits some parting of the USMCA clouds and the unleashing of pent-up business investment. This could propel the economy 2.2% in 2027, which would be the best year since 2022 and a step up from the average 1.9% rate of the past three years.

Given the inflationary threat from higher energy prices, markets are pricing in a quarter-point rate increase from the Bank of Canada later this year. We deem this unlikely. Prior to the Iran conflict, core inflation was drifting back toward the 2% target due to weakness in the economy. We suspect policymakers will look past the oil-driven rise in prices and remain wary of economic risks until the fog from both the Iran war and the trade war lifts, keeping overnight rates at modestly supportive levels. We see no change in the current 2.25% policy rate this year or next. Meantime, assuming the Fed pulls the easing trigger again, narrower interest-rate spreads with the U.S. could lift the Canadian dollar to US$0.75 by year-end.