Scenarios for the U.S.-Canada Economic Relationship

The United States and Canada have enjoyed a long and fruitful relationship that dates back more than 150 years and has grown to encompass deep economic, cultural, and political ties. Side by side, our countries prevailed in both world wars and the Cold War, and with the triumph of the West at the dawn of the 1990s, unprecedented steps were taken to thin our common border and integrate our economies. The 21^st century was to be one of economic liberalism, and the U.S.-Canada relationship was to exemplify all that free markets and free trade have to offer.

Prepared with files and support from the entire BMO Economics team

Earlier steps toward economic integration were always understood to be part of a one-way trip, but that assumption is now being challenged. In the United States, President Trump has maintained his popularity in part by tapping into a deeply rooted suspicion of free trade held by parts of the electorate. That wariness is not entirely unfair, as the benefits and costs of globalization have not been shared equally. Unfortunately, the U.S. administration has also embraced the unorthodox notion that trade is often zero-sum in nature, and that running a trade deficit means you’re losing (or even being preyed upon).

The argument for free trade does not need to be re-litigated here in any depth. Trade permits greater specialization and unleashes economies of scale, and thereby lowers production costs and lifts living standards. It is a positive sum undertaking. It would be counterproductive to erect trade barriers between states, provinces, cities, or neighbourhoods; they are equally illogical between friendly and like-minded nations. Large and persistent trade deficits can sometimes reflect underlying economic imbalances and therefore bear monitoring, but to focus only on the balance of trade is to miss the point.

Exactly where U.S. trade policy will land, and how trading partners will respond, is still highly uncertain. Over the past nine months, the administration has increased tariffs against virtually all trading partners and the levies continue to evolve week by week. In a welcome move toward stability, the U.S. has negotiated tentative agreements with some of its largest overseas trading partners—however, the deals have yet to be ratified and have been largely one-sided, which casts doubt on their durability. The outlook is further clouded now that many U.S. tariffs are in limbo before the courts.

Canada, after initially finding itself squarely in the administration’s crosshairs, has avoided across-the-board tariffs for the time being. However, the situation remains fluid and North American trading arrangements will return to the fore with the joint review of the USMCA/CUSMA, which must be held by July 2026 (we’ll use “USMCA” in this report). The review process will give all sides an opportunity to air grievances, demand changes, and posture. A constructive outcome would help assure businesses and investors that the North American economic project remains intact; a bad one could upend continental trade and the economy.

This report identifies several possible paths forward for the U.S.-Canada trading relationship and considers their potential economic impact on both sides of the border. We find that even in an optimistic case, the damage already done to cross-border goodwill and confidence will impede business investment and growth for some time. At the other end of the spectrum, a large increase in tariffs would virtually assure a significant economic downturn in Canada, and, while the impact in the U.S. would be less dire, it would add to other headwinds. Regional and industry effects would vary widely, with some sectors faring relatively well and others coming under existential pressure. However, neither markets nor policymakers would stand idly by. Exchange rate adjustments, easier monetary policy, potential fiscal stimulus, and (in Canada) trade policy reorientation would help to soften the blow.

Before diving into the scenarios, we survey the history of the U.S.-Canada economic relationship, take stock of recent events, and put the upcoming USMCA review into context. To close, we peer above the current fray and consider areas for greater cooperation in the future.

A Brief History of Trade Across 49°

The U.S. and Canada have long had a special economic partnership, albeit with some ups and downs over time. Economic ties stretch back to the formative years of our countries. In the mid-19^th century, with the War of 1812 a distant memory and the western border ironed out a decade earlier, the U.S. and British North America (as Canada was then known) negotiated the Reciprocity Treaty of 1854, which lowered tariffs on natural resource products. The agreement lasted little more than a decade, but reciprocity (i.e., free trade) continued to be pursued in fits and starts by advocates on both sides. Unfortunately, it would take the better part of a century to regain traction.

In the early 1900s, the U.S. increasingly opened itself to international trade as it stepped into its new role as the world’s largest economy. By the turn of the century, U.S. trade already amounted to more than 10% of GDP (Figure 1). However, it flowed primarily across the Atlantic, and Europe became a crucial outlet for rapidly growing U.S. industrial output, accounting for three-quarters of U.S. exports and more than half of imports. Canada, with its much smaller economy, accounted for just over 5% of U.S. trade. With much to gain, the possibility of bilateral free trade became a central issue in the 1911 Canadian federal election, but lost the day due to concern about potential U.S. dominance. Two decades later, the Great Depression brought sharply higher tariffs on both sides of the border, with Congress enacting the infamous Smoot-Hawley Act and Canada retaliating in kind (Figure 2).

The economic relationship warmed as the world exited the Depression, fought World War II, and entered the post-War era. Commercial trade between the U.S. and Europe had collapsed during the war and remained weak in its aftermath, despite efforts to rebuild the continent. Meanwhile, the North American economy roared ahead, physically undamaged and in the midst of an unprecedented baby boom. With the U.S. consumer now the world’s most important engine of growth, trade became a less important part of the country’s economic fabric. However, Canada was able to secure a larger piece of that pie. Less wary of its southern neighbour, its share of U.S. trade jumped to more than 20% of the total.

Decades of rapid globalization followed, spurred in part by the ever-present tensions of the Cold War. For the U.S. and Canada, close cooperation on security in the north made tighter economic ties feel natural and the two countries began to put major bilateral deals to paper (Figure 3). Trade expanded elsewhere, too. A reimagined Japan underwent its economic miracle and embraced globalization wholeheartedly. The East Asian tigers did the same. Western Europe experimented first with economic and then political union, later to be joined by a host of former Soviet Bloc members. With the U.S. at the economic centre of it all, trade more than tripled as a share of its economy by the turn of the millennium. Canada, with its newly minted trade deals, was able to ride that wave.

The first major bilateral trade agreement between the U.S. and Canada was the Auto Pact, signed in 1965, which integrated vehicle production between the two countries. After a devastating recession in the early 1980s, the Canadian government sought ways to strengthen the economy and all signs pointed south. Negotiations on a comprehensive free trade deal began in 1986, and the two sides announced the Canada-U.S. Free Trade Agreement (CUSFTA) little over a year later. However, the possibility of free trade remained controversial across much of Canada and the deal was ratified only after a highly contentious federal election in 1988. The push for an expanded deal including Mexico began in the early 1990s. The idea of a trilateral deal proved politically divisive in the U.S., but the three amigos eventually signed the North American Free Trade Agreement (NAFTA), which took effect in 1994.

The early 2000s were in some ways a high-water mark for economic liberalism and U.S.-Canada trade. Since then, U.S. merchandise trade has declined slightly as a share of the economy, though services trade has done somewhat better. Canada has also had a tougher go in the U.S. market. Its share of U.S. trade has declined by around one-quarter amid inroads by China, Mexico, and others. In part, these developments are flip sides of the same coin. As emerging-market producers became more competitive, the resulting pressure on the U.S. manufacturing sector affected its demand for natural resources and other Canadian inputs. Both countries have to some extent pivoted toward the Pacific.

The decline of U.S. manufacturing employment, and the resulting social impact, were key factors behind President Trump’s rise to power in 2016. In reality, the long-term slide in manufacturing employment has been more rooted in technological advancement than overseas competition; since the turn of the century, real manufacturing output has been little changed despite the sector shedding around 5 million jobs. Still, overseas competitors have not always played fair. China’s ascent was partly driven by welcome market reforms beginning in the 1980s, but it also engaged in blatant mercantilism in its pursuit of export-led growth, and it has never been alone in its use of such tactics. With this backdrop, it was easy to blame foreign trade for many of America’s woes.

The U.S.-Canada relationship was bruised, but not broken, during the first Trump administration. At the time, the President denounced NAFTA as “one of the worst trade deals ever” and warned that he would withdraw from the pact. In 2018, he imposed tariffs on imports of Canadian steel and aluminum on national security grounds. Nevertheless, the two sides (and Mexico) eventually came to the table and negotiated a successor deal, the U.S.-Mexico-Canada agreement (USMCA), which entered into force in 2020.

USMCA negotiations were at times acrimonious, but produced a fairly balanced deal that retained free trade as a core principle. For its efforts, the U.S. obtained tighter country-of-origin rules in the auto space, stricter intellectual property protections, higher de minimis limits, and greater access to the Canadian dairy and poultry markets. In exchange, Canada was able to retain aspects of NAFTA that it viewed as critical, including the dispute resolution mechanism for countervailing and anti-dumping duties, protections for cultural industries, and its supply management system. The USMCA handed the Trump administration an important symbolic victory and was heralded by the President as “truly historic”, but if you squint, it ended up looking a lot like NAFTA. Most ominously, the U.S. sought and obtained a review and sunset mechanism, which is now returning to the fore.

It’s difficult to overstate the degree of economic integration between the U.S. and Canada (Figure 4), even as trade has gravitated East over the past two decades. Of course, the relationship remains far from symmetrical. Canada famously relies on the U.S. as a destination for about 75% of its merchandise exports, equivalent to 19% of GDP in 2024. Factoring in exports of services like travel, transportation, and commercial services puts total exports to the United States at 23% of Canadian GDP. In the other direction, Canada is the largest single-country market for U.S. merchandise exports, but the immensity of the U.S. economy and its greater diversification leaves northbound shipments at a comparatively modest 1.2% of U.S. GDP. Even counting services, exports to Canada amount to only 1.5% of U.S. GDP. It goes without saying that Canada has far more at stake in any cross-border economic dispute, though many U.S. states and industries have plenty of skin in the game.

Nor are economic linkages confined to trade; cross border investment is also significant. At the end of 2024, U.S. investors had Canadian asset holdings equivalent to US$2.5 trillion, or around 9% of GDP, with concentrations in direct investment, debt securities (including Government of Canada bonds), and deposits (Figure 5). In the other direction, Canadian investors held an estimated US$2.7 trillion in U.S. assets, equivalent to almost 120% of GDP and concentrated in similar types of holdings. Moreover, these numbers represent only book value estimates; the data on market value holdings is limited but suggest that cross-border investment could be perhaps twice as large at current prices. Canada’s relatively larger net investment position in the U.S., which amounts to roughly US$170 billion, is the flip side of the moderate bilateral trade imbalance between the two countries over the past few decades. Although Canada has exported more goods to the U.S. than the other way around, the U.S. has sold more financial assets to Canada.

Shock and Awe in 2025

It would be an arduous task to recount each maneuvre in this year’s multi-front trade dispute, and we won’t try to do so exhaustively. Canada, for its part, was singled out even before President Trump took office, although notably not until after the election. Shortly after inauguration, the administration declared that almost all imports from Canada would be subject to a 25% tariff, with the levy to take effect in early February (a lesser 10% rate was applied to energy and critical minerals). At the eleventh hour, the administration granted a month-long reprieve, and then allowed the tariffs to briefly take effect in March before narrowing their application to non-USMCA compliant goods (perhaps 5% of southbound Canadian exports). Later, select Canadian exports including steel, aluminum, non-U.S. auto content, and some copper products became subject to sectoral tariffs ranging from 25% to 50%. In August, the administration raised the tariff on non-USMCA imports from Canada to 35%, where it stands to this day. Most recently, the administration has unveiled new sectoral tariffs on lumber, pharmaceuticals, and heavy trucks. All of this, ironically, on what would have been the Auto Pact’s 60th anniversary.

Canada’s response has been measured, but not meek. In early March, it placed a 25% tariff on around $30 billion of imports from the U.S. and vowed additional retaliation absent a stepdown. The U.S. ended up narrowing its tariffs to non-USMCA products fairly quickly, but its sectoral tariffs led to Canadian retaliation on another $30 billion in imports, including steel, aluminum, and consumer products. In general, Canada’s countermeasures have been designed to pressure some of the President’s key constituents, while focusing on products that Canada can produce domestically, obtain elsewhere, or potentially do without. In September, Canada discontinued around half of its retaliatory measures as an olive branch heading into the USMCA review, but its response to U.S. sectoral levies remains in place. In June, the country rescinded its new digital services tax just days before it was to go into effect.

Overall, we estimate that the U.S. average effective tariff rate on imports from Canada has increased to around 7%, up from virtually nil last year. Canadian tariffs in the other direction have also increased but average less than 1%. Greater uncertainty and higher tariffs have already had a measurable impact on bilateral trade, which surged early this year as companies attempted to front-run looming tariffs but has now settled into a noticeable funk (Figure 6). At first, trade declined as firms worked through the extra goods purchased earlier in the year, but it has remained subdued even as inventory investment has normalized. According to U.S. data, which are less affected by this year’s large Canadian dollar movements, nominal imports from Canada were down 4.4% year-over-year through the first seven months of 2025; northbound exports declined 3.2% over the same period.

Of course, the U.S. trade conflict has embroiled not only Canada. In April, the administration introduced its Liberation Day tariffs, which included a 10% global baseline levy (that spared USMCA partners) and country-specific reciprocal tariffs based on each partner’s bilateral balance of trade. Together with triple-digit levies on imports from China, this briefly lifted the average effective U.S. tariff rate on imports from all countries to around 28%, the highest level since the early 1900s (and up from just above 2% last year). After a fierce plunge in financial markets, the administration granted a 90-day reprieve on reciprocal tariffs and dialed back levies on China several weeks later, but kept in place its 10% global baseline tariff, all sectoral tariffs, and an earlier 20% tariff on China.

The U.S. used the breathing room granted by its tariff ceasefire to negotiate a spate of tentative trade deals with some of its largest overseas trading partners. Understandings were secured with countries accounting for more than one-third of U.S. imports, including the United Kingdom, European Union, Japan, Vietnam, South Korea, Malaysia, Indonesia, and the Philippines. However, the agreements, which mostly have yet to be put to paper, ended up strikingly one-sided, with U.S. partners generally accepting one-way tariffs between 10% and 20% and in some cases lavishing the U.S. with promises of greater investment and imports. In exchange, they were spared the larger reciprocal tariffs, and some were granted relief on sectoral levies in the form of tariff-rate quotas. Although the deals have somewhat reduced economic uncertainty, they have also fomented popular resentment in the countries that struck them. The agreements, together with another deferral for China (until November) and a round of new reciprocal tariffs against lesser trading partners, have put the average U.S. tariff rate at about 18% today.

Now, it appears that the Trump administration may have exceeded its authority in imposing various blanket tariffs this year. Ultimately, the U.S. constitution gives Congress the exclusive power to establish taxes and duties, but there are laws that delegate this authority to the President in certain circumstances. Most of the broad tariffs imposed this year have been established under the International Emergency Economic Powers Act of 1977 (IEEPA), which gives the President broad authority to “regulate” economic transactions following the declaration of a national emergency.

IEEPA was the legislative basis for the administration’s short-lived universal tariffs on Canada, ostensibly in response to the movement of fentanyl across the border. It also underpins the reciprocal and global baseline tariffs, but in those cases, U.S. trade deficits were deemed to constitute a national emergency on their own. However, tariffs are a novel use of IEEPA authority, which is typically used to impose sanctions. In August, a federal appeals court upheld a lower court ruling and declared all IEEPA tariffs illegal, finding that the power to regulate does not convey a power to tax (and tariffs are, in every sense, a tax). However, the court permitted the levies to remain in place until the Supreme Court takes up the case in early November.

If the Supreme Court strikes down the administration’s IEEPA tariffs, then the situation will once again become much more fluid. For one thing, recently negotiated trade agreements could be abandoned if overseas counterparties feel that the bargaining landscape has shifted in their favour. The administration would still have other tariff options in its arsenal, but they are somewhat more limited (Figure 7). For example, under Section 122 of the Trade Act of 1974, the President has authority to impose tariffs in response to large and persistent trade deficits, but any such levies are limited to 15% and 150 days (absent an extension by Congress).

More consequentially, Section 232 of the Trade Expansion Act of 1962 authorizes the President to restrict imports of select products if it is determined that they threaten national security, which is defined to encompass the general security and welfare of key industries (Figure 8). This statute is the legal basis for the administration’s sectoral tariffs. Its powers are narrower than those offered by IEEPA and there are greater procedural controls, including the requirement for a Department of Commerce investigation, but 232 tariffs have already been deployed to significant effect. With a long list of 232 investigations currently in the pipeline, the trade situation is likely to remain volatile even if IEEPA tariffs are defused.

USMCA: Here Comes the Sunset Clause

Recent events have created a tense and potentially combustible environment heading into the upcoming USMCA review, which is slated to begin by July 1^st, 2026. The review process is part of the USMCA’s sunset mechanism, which stipulates that the deal automatically expires after 16 years unless all three member countries agree to extend it. Fortunately, there is a long runway. If the parties cannot reach an agreement next year, the review process is to be repeated annually, and the agreement will expire only if no compromise is reached by 2036. However, there is a nuclear option, as any party can unilaterally withdraw with six months notice.

U.S. administration officials have already made it clear that they intend to renegotiate the USMCA, rather than renew it in its current form. After several months of public consultations and hearings, which are now underway, the Office of the U.S. Trade Representative (USTR) will report to Congress in January with a strategic vision for negotiations. That will set the tone for the multilateral talks to follow. A key question is whether the President will seek Trade Promotion Authority (TPA) from Congress. TPA would allow the USTR to renegotiate all aspects of the USMCA, not just those on the periphery, and would signal to Canada and Mexico that deep change is expected.

If the original USMCA negotiations are any indication, the U.S. administration could use the possibility of withdrawal to try to squeeze concessions from Canada and Mexico. The legalities have never been tested, but it appears that the President could pull the U.S. from the agreement without sign-off from Congress (which might not object in any event). That possibility will make the potential level of tariffs in a post-USMCA world a central issue and puts additional weight on the Supreme Court’s upcoming decision. If the administration’s ability to impose tariffs at will is constrained, then the balance of power in USMCA negotiations could be somewhat less skewed. However, Section 122 and 232 tariffs would still be in play.

Tariffs aside, there is no shortage of recurring trade irritants that could be tabled during the USMCA review. On the U.S. side, auto content rules, supply management, intellectual property, and cross-border investment will be front and centre. As in 2018, Canada’s strategy will necessarily be more reactive as it strives to maintain valued protections in a relationship that will always be deeply lopsided. One priority will be to obtain additional assurances that Section 232 and other tariffs will not be re-weaponized.

Scenarios for U.S.-Canada Trade

Economic forecasting is challenging at the best of times, which these are not. With politics and personalities at play more than economics, the path forward for U.S.-Canada trade is difficult to anticipate and the range of possible outcomes is wide. Rather than trying to predict the unpredictable, we estimate the potential economic impact of several stylized scenarios, ranging from relatively benign to extremely damaging. Our aim is to establish a handful of useful reference points while acknowledging that reality could ultimately fall somewhere in between.

We make a number of simplifying assumptions. First, we narrow our consideration to North American trading arrangements and assume that terms between the U.S. and overseas partners remain little changed. We confine our analysis only to various tariff outcomes, which are assumed to become effectively permanent; we do not consider other types of border thickening. Commitments made as part of WTO membership are assumed to be irrelevant. Canada is assumed to partially match U.S. tariffs, which would be a departure from the structures that the U.S. has negotiated with other countries but could be a political imperative in Canada. For the purpose of estimating U.S. impacts, Mexico is assumed to accept similar terms to Canada, and it is assumed that trade between Canada and Mexico is not disrupted (either way, it is small). Economic impacts incorporate an expected central bank response, but not a fiscal reaction, which would provide an additional lift but is less certain in size. We do not make an explicit assumption about timing, as it matters little to our overall conclusions whether a deal is secured quickly or negotiations drag.

Under our methodology, both countries are assumed to have an import price elasticity of -0.8, so that a 1% increase in import prices yields a 0.8% decline in import volumes. This is a relatively conservative assumption and reflects that (1) Canada would have difficulty finding domestic substitutes for many U.S. imports, and (2) with the U.S. economy operating close to capacity, its ability to substitute would be similarly constrained. The Canadian dollar is assumed to depreciate by 10% in the most severe outcome, which helps to offset the impact on net trade; the U.S. dollar, on a trade-weighted basis, is little affected. Tariffs are assumed to pass through entirely to consumer prices over time, as is part of the currency impact in Canada. The resulting decline in domestic purchasing power is assumed to undercut real consumer spending on a roughly one-for-one basis. Business investment is assumed to decline by 15% in Canada in the most severe scenario; this impact was calibrated in part based on the experience so far this year. U.S. business investment is assumed to decline by around 1% in the most severe scenario, reflecting the larger size of the U.S. economy and limited fear about economic knock-on effects. The resulting impacts have been rounded so as not to give an undue air of precision.

The following sections address potential macroeconomic impacts, which are summarized in Figure 9. Industry and regional sensitivities are considered further below.

Scenario #1: Free Trade Muddles Through

A benign outcome: 7% average tariff in U.S. (i.e. no change) and 2% in Canada

It’s worth recognizing that the U.S.-Canada relationship could still get through this rocky patch mostly unscathed. Rhetoric aside, politicians on both sides seem to recognize the damage that broad tariffs would do to the North American economy and its competitiveness in global markets. Even the administration seems to appreciate the perils of abandoning free trade completely, which would weigh disproportionately on the manufacturing sector, one of its key constituencies. If the President thought broad tariffs against Canada were a good idea, they would probably already be in place.

In a “Muddle Through” scenario, continental free trade mostly endures, with no across-the-board tariffs imposed by either side. However, sectoral U.S. levies remain in place for steel, aluminum, lumber, and select other products. The average U.S. tariff rate on imports from Canada remains around 7%, where it stands today. Otherwise, the administration is assumed to settle for minor adjustments and perhaps non-trade commitments on border security and defence. In this scenario, Canada adds modestly to its existing countermeasures, but not so much as to provoke a further U.S. response, raising its average tariff rate to 2% from less than 1% today. The new tariffs could be accepted as part of an amended USMCA or a new trading framework, or the two sides could dispense with formalities and leave the USMCA question for another year.

This is not a best-case outcome, which would have both sides dismantle all tariffs, yielding better economic conditions than described here. However, it would be a welcome result after nine months of turbulence. It’s also a reasonable baseline expectation (i.e., most likely path forward), and as such, our official macroeconomic forecast is built upon roughly this operating assumption. Importantly, even if average tariffs remain fairly low, it is doubtful that any agreement could fully assuage fears about a future flare-up in tensions. After all, the USMCA has offered only limited shelter from this year’s instability.

On its own, a “Muddle Through” scenario would have a small macroeconomic impact in the U.S., given its much larger economy and lesser reliance on trade with Canada (and Mexico). Over time, economic activity would end up perhaps a tenth lower than otherwise, and the price level perhaps a tick higher. However, these figures represent the stand-alone impact of greater frictions in continental trade, which accounts for less than one-third of the U.S. total. Imports from other U.S. trading partners are facing significantly higher tariffs, which will yield a more material impact on U.S. growth and inflation.

In Canada, sectoral tariffs and lingering uncertainty would create a more noticeable drag for the economy. Business investment would remain under pressure. Some companies could benefit from comparatively better access to the U.S. than their overseas competitors, but many would be hesitant to expand capacity in Canada. The labour market would likely weaken somewhat further, though widespread job losses would be unlikely and improved confidence would eventually support consumer spending. Export volumes would slide, especially in industries targeted by tariffs, but a weak loonie and sluggish import growth would prevent net trade from weighing excessively on the economy. Over time, Canadian economic activity would fall perhaps 1%-to-2% below the path expected at the start of 2025; the economy would continue to grow, but at a subdued pace. Inflation could initially slow somewhat in the sluggish growth environment, but prices would eventually adjust around 1% higher due to the weak currency and domestic tariffs on some U.S. imports.

BMO’s baseline economic forecast captures these general dynamics but incorporates the impact of both continental and trans-oceanic trade turmoil (Figure 10). Both considered, U.S. real GDP growth is expected to average a moderate 1.8%-to-1.9% annualized this year and next, lifting the unemployment rate slightly to 4.6%. Inflation should continue to ease toward target, but higher tariffs will prolong the adjustment. As a result, the Federal Reserve is expected to normalize policy only gradually, with rates cumulatively lowered by 1.25 percentage points to just under 3% at the end of next year, slightly below the estimated neutral range.

Unsurprisingly, the baseline forecast for Canada is weaker. Growth is expected to average 1.3% annualized in 2025 and 2026, lifting the unemployment rate to 7.3%. Headline inflation is expected to remain relatively close to the 2% target, but core inflation should slow further in the sluggish economic environment. That would pave the way for additional easing by the Bank of Canada, which is expected to cut by another 50 bps to 2.00% by early 2026, putting monetary policy in slightly stimulative territory. Net trade and growth should also be supported by a relatively weak loonie, though the currency could become somewhat less supportive as the U.S.-Canada interest rate differential narrows.

On both sides of the border, the current forecast is meaningfully weaker than at the beginning of the year, before tariffs started to escalate. At the time, lower interest rates were expected to lift Canadian economic growth to around 2% this year, and the U.S. expansion was expected to be even stronger than that.

Scenario #2: No Special Treatment

An adverse outcome: 15% average tariff in U.S. and 5% in Canada

One discernable pattern through all of this year’s instability is that the administration has repeatedly tried to establish a broad regime of low-double digit tariffs. In April, when it suspended the large reciprocal tariffs that had put markets into a tailspin, the 10% global baseline tariff was retained (though it was not applied to Canada and Mexico). In some subsequent trade deals, the administration secured similar tariff rates in the 10%-to-15% range with some of its largest trading partners. It could be that the possibility of very large tariffs is being used to make moderate ones more palatable.

In a “No Special Treatment” scenario, the U.S. imposes across-the-board tariffs averaging 15% on imports from Canada, though levies could be higher in some sectors. The administration either withdraws from the USMCA, disregards it, or establishes the tariffs as part of a new trade framework, as it has with other countries. Unlike overseas partners, Canada is assumed to retaliate with tariffs of its own—a conservative assumption that results in a larger economic impact. But, cognizant of the costs and fearful of inciting U.S. escalation, the average Canadian tariff rate is kept to a lesser 5%.

Recent U.S. deals make this outcome easy enough to envision, but Canada is intertwined with the U.S. in a way that overseas economies are not. Famously, products like automotive assemblies can crisscross the border five or more times during production. Tariffs on the gross value of cross-border shipments would compound repeatedly in these industries, putting U.S. and North American products at a major disadvantage to overseas competitors, even within North America. This seems to be recognized by the administration, which currently applies sectoral tariffs only to the non-U.S. content of auto imports from Canada and not at all on compliant parts. In this scenario, as well as the more severe scenario that follows, both sides are assumed to implement tariffs in this manner.

Such a scenario, while worse than the status quo, would still have a limited macroeconomic impact in the U.S. For the most part, Canada’s 5% average tariff could be absorbed into profit margins or passed into prices without too much impact on activity, though higher levies could have a greater impact in some industries. Overall, such an outcome could carve perhaps 0.4% from U.S. real GDP over several years, relative to earlier growth expectations, while adding around 0.4% to prices. On its own, it would represent a manageable growth headwind and give a temporary lift to inflation. It would be unlikely to move the needle for the Federal Reserve but would add to damage caused in other theatres of the trade dispute.

The economic impact in Canada would naturally be more significant, yet still manageable. Job losses in the most trade-oriented industries would weigh on consumer spending and wage growth but would be unlikely to cascade across the broader economy. Business investment and exports would decline materially, but net trade would be supported by lower imports and likely a modest further depreciation of the loonie. Growth would slow noticeably and, over time, economic activity could fall around 2.5% below pre-tariff trends. A technical recession would be a strong possibility, but any downturn would probably be short-lived. Moreover, tariff revenues would be significant and would almost certainly be recycled to support affected industries.

Although greater economic slack could initially weigh on inflation, the Bank of Canada would remain wary of longer-term pricing pressures and would be hesitant to cut rates much below 2%. After complete adjustment, which would likely take several years, consumer prices could rise by perhaps 1%-to-2%. The increase in prices would reflect the higher cost of U.S. imports, less efficient small-scale production of domestic replacements, and greater transportation costs for overseas substitutes.

Scenario #3: Continental Divide

A worst-case outcome: 35% average tariff in U.S. and 15% in Canada

Unfortunately, it is also possible that USMCA negotiations will go off the rails. Hardline negotiating tactics on either side could backfire. In Canada, the public may want to go toe-to-toe in any negotiating row despite the two countries’ very different weight classes. Meantime, U.S. negotiators are keenly aware that they have much less on the line than Canada and could choose to press that advantage. Cooler heads may not prevail.

In a “Continental Divide” scenario, we assume that the U.S. implements a 35% tariff wall against all imports from Canada. That is the current rate being applied to non-USMCA products and will serve as a natural reference point in negotiations. Canada, in response, imposes an across-the-board 15% tariff on imports from the U.S.—enough for the government to avoid the appearance of bending the knee, yet calibrated to avoid further escalation. As above, it is assumed that tariffs apply only to foreign content, which helps to limit the damage. This is not literally the worst outcome imaginable—one can always posit higher tariffs—but it is the worst that has a basis in recent rhetoric.

Such a scenario would have a meaningful impact on the U.S. economy. Canada’s 15% average tariff would put U.S. industries at a material disadvantage north of the border. Sectors with significant exports to Canada, narrow margins, and foreign competitors could struggle. Northern states, many of which count on Canada as their number one export market, would slow. But even in the most-affected U.S. sectors and regions, reliance on trade with Canada is small compared to the other way around. Even in the most exposed U.S. industries, less than 10% of sales go north, while in the most vulnerable states, exports to Canada generally account for less than 5% of GDP.

However, larger U.S. tariffs would also undermine domestic purchasing power, lifting prices by perhaps 1% over time. All together, the impact on real consumer spending, investment, and trade could eventually lower economic activity by around 1% relative to pre-tariff trends. On its own, such a scenario would yield slower, but not negative U.S. growth. However, the impact would add to other trade headwinds. Rising prices and a deteriorating labour market would present the Fed with an uncomfortable dilemma. Unless confronted with signs that higher inflation was becoming entrenched, it would likely act more quickly to bring rates down to neutral territory, or somewhat below.

In Canada, a recession would be virtually assured. A 35% tariff in the U.S. market would leave Canadian products at an enormous disadvantage to both U.S. and overseas competitors and would be too large to absorb into profit margins. Exports would plunge, and so too would business investment. Although lower imports would lessen the pressure on net trade, the decline would mainly reflect weakening domestic demand. Easing by the Bank of Canada would help stanch the damage, but its response would be constrained by concern about pricing pressures. The policy rate would likely be cut well into stimulative territory, but not to the lower bound, perhaps bottoming around 1%.

In the first year or so, real GDP in Canada would decline perhaps 1%-to-2%. The unemployment rate would jump by 1.0-to-1.5 percentage points, reflecting major job losses in industries reliant on U.S. trade and cascading effects across the rest of the economy. Over time, economic activity would likely end up around 5% below pre-tariff growth trends. With the economy in recession and interest rates in decline, the Canadian dollar could lose perhaps 10% of its value, which would partly offset the U.S. tariff and would give Canadians another reason to buy domestic. However, it would also weigh further on domestic purchasing power. Over time, the price level could rise perhaps 4%. The government would almost certainly respond with stimulative fiscal policy, which would help buoy economic activity but would also worsen pressure on prices. Canada would seek deeper economic ties elsewhere, but they would take time to establish, and trade would be costlier over long distances.

Markets would react to all of this in short order. Equities would decline and corporate spreads would widen, perhaps significantly. Canadian assets would naturally be hardest hit, but U.S. markets could also struggle given elevated starting valuations, tensions with other trading partners, and broader concerns about economic and fiscal policy. The market downturn would be caused by, and then ultimately contribute to, the adverse economic outcome. Long-term government bond yields would probably decline moderately, as occurred earlier this year, provided that inflation expectations remain anchored.

Such an outcome would provoke deep structural change across the North American economy, much of which would only be felt over the long term. In Canada, firms would be reluctant to strand fixed assets but would likely favour the U.S. for new investment. Productivity, already struggling, would remain under pressure. The U.S. would likely see some individual victories on investment, but it would ultimately be worse off with a more compartmentalized North American economy. Both sides would find it more difficult to compete against overseas regional value chains. On both sides, real incomes would be relatively lower and consumer choice relatively narrower.

What’s at Stake: Industry and Regional Sensitivities

Higher tariffs would be unambiguously negative for the North American economy as a whole, but the impact would vary widely by industry and region. In principle, a two-way increase in tariffs could affect an individual firm through three distinct channels: (1) foreign tariffs could make its products less competitive across the border; (2) domestic tariffs could increase its costs; and (3) domestic tariffs could boost its sales to domestic buyers. All else equal, tariff vulnerability should therefore be greatest in industries that export intensively, rely heavily on imported inputs, and face a limited domestic market for their products. Reality, however, is a bit more complicated.

The biggest complexity is that, ultimately, an increase in tariffs would not necessarily be shouldered by the importers responsible for paying them. Prices can and would adjust, which would redistribute the economic hardship in ways that are difficult to generalize. Some exporters might find that cross-border demand is relatively insensitive to tariffs, while others might need to slash prices to prevent a large decline in sales. Some importers might be able to pass tariff costs on to their customers, while others could be forced to accept narrower margins. Some buyers might be able to substitute alternative products, while others might face prohibitive switching costs. Pre-tariff trading patterns are just part of the story; industry structure is central (Figure 11).

All of this makes it difficult to gauge industry-level sensitivity precisely. We content ourselves to focus on just one aspect of the issue: reliance on cross-border sales. Roughly speaking, the share of exports in an industry’s overall sales indicates the amount of revenue at risk in an adverse trade outcome. Conveniently, there is an abundance of relevant data available, especially relating to the manufacturing sector, where cross-border integration is tightest. We follow with a look at cross-border export dependence by region.

Canadian Industries and Regions

Canada’s overall reliance on trade with the U.S. naturally results in some extreme industry-level vulnerabilities. This is especially true in the manufacturing space, which accounts for 54% of U.S.-bound exports (Figure 12) and relies on those exports for 45% of industry sales (Figure 13). The question of tariff vulnerability in manufacturing is not purely hypothetical, either. A variety of manufactured goods are already being targeted by Section 232 tariffs and many more are the subject of pending investigations.

Among top-level manufacturing segments, electrical equipment and appliance producers are by far the most reliant on the U.S. market. Southbound exports account for more than 80% of the segment’s sales, and appliance manufacturers already face sectoral tariffs on the steel and aluminum content in their products. Machinery manufacturers are also highly dependent on exports to the U.S., which comprise roughly two-thirds of total sales. Operators in this segment produce a diverse range of products spanning industrial, commercial, and agricultural uses, yet no individual subsegment relies on the U.S. market for less than 40% of revenue. Computer and electronics manufacturers also depend on the U.S. for around two-thirds of sales. Within the segment, semiconductors and related products account for around one-quarter of revenue and are the target of an ongoing Section 232 investigation.

Transportation equipment manufacturers are also highly dependent on cross-border trade, with southbound exports amounting to almost two-thirds of total sales. Canadian automakers, having integrated tightly across the border, rely on the U.S. for more than 90% of sales, while 55% of auto parts also go south. Troublingly, Canadian vehicles are already subject to a 25% tariff on non-U.S. content and the U.S. administration has announced a similar charge on heavy trucks. Aerospace manufacturers are slightly less dependent on the U.S. market, but still rely on it for almost half of sales. Commercial aircraft and jet engines are the subject of another 232 investigation.

Chemical manufacturers are next most dependent on the U.S. market, with southbound exports accounting for 65% of sales. Reliance varies widely by sub-segment but is highest in pharmaceutical products, where the administration is pursuing a 100% tariff on name-brand patented drugs. Producers of primary metal products, wood products, and furniture also have large U.S. exposures and are now subject to sectoral tariffs on steel, aluminum, and copper and, soon, on lumber, cabinets and select furniture. Even the most insulated parts of Canadian manufacturing rely on the U.S. for almost 10% of sales and therefore have a plenty at risk in the current environment. Very few parts of the sector can rest at ease.

Tariff vulnerability is more moderate outside the manufacturing sector. Although Canada exports energy products to the U.S. intensively, the administration has shown little interest in imposing large tariffs on such trade. The service sector generally has limited exposure to U.S. tariffs, given its low reliance on exports, though the film industry could struggle if the administration follows through with proposed tariffs on foreign movies and television. Wholesalers and retailers would also be vulnerable if large tariffs were put in place by Canada.

From a regional standpoint, all Canadian provinces are to some extent vulnerable to U.S. tariffs, but there are major differences in degree (Figure 14). Alberta relies most heavily on sales to the U.S., which amount to almost 35% of provincial GDP, but it sells mainly oil and gas, which are lower risk. Exports to the U.S. from Saskatchewan, New Brunswick, and Newfoundland and Labrador also have large energy components. Non-energy exports are highest in central Canada and some of the maritime provinces. Both Ontario and Quebec rely on non-energy exports to the U.S. for around 15% of GDP, with Ontario specializing in autos, steel and consumer goods and Quebec geared more toward resource products and aluminum. However, the highest non-energy exposures are in New Brunswick and Prince Edward Island, with Manitoba rounding out the top five. British Columbia and Nova Scotia engage in comparatively little U.S. trade, with southbound exports accounting to around 7% of GDP. That is far from negligible, but implies much less vulnerability than in other provinces.

U.S. Industries and Regions

As above, we confine our attention to the manufacturing sector, but we consider U.S exports to both Canada and Mexico (the scenarios described above assumed similar trading arrangements with both). On a combined basis, U.S. manufacturers rely on USMCA partners for 8.4% of sales (Figure 15), but cross-border reliance goes far beyond that in some industries (strictly speaking, gross output is the denominator used for these calculations, but we’ll use “sales” for brevity). Electrical equipment and appliance manufacturers rely on Canada and Mexico for more than 20% of sales, and producers of computers, electronics, and apparel are not far behind. Machinery and transportation equipment round out the list of top-level manufacturing segments with double-digit reliance on USMCA exports. All of these segments would be vulnerable to a broad increase in continental tariffs, though perhaps tellingly, most were not targeted by Canada’s retaliatory tariffs this year (autos being a notable exception).

Reliance on trade is modest outside the manufacturing sector, but there are pockets of vulnerability in travel and tourism. Already, Canadian visits to the U.S. are down about 30% this year, as northerners have redirected their vacation dollars in protest of U.S. trade policy and rhetoric. That won’t make much of a dent in New York City, but it is a big deal in smaller destinations close to the border, as well as in Las Vegas, a popular destination for Canadian travelers.

U.S. regional sensitivities are largely determined by geography, with states located closer to the border generally more reliant on trade across it (Figure 16). North Dakota is most reliant on exports to Canada, with northbound sales totaling almost 7% of GDP, reflecting large shipments of oil, gas, and refined petroleum products. Next is Michigan, with more than half of Canada-bound exports relating to vehicle production. Perhaps unsurprisingly, seven of the states with top-ten exposures to Canada are found in the Midwest, selling a diverse mix of products into central Canada. Kentucky also features surprisingly high on the list—and it’s exporting a lot more than just bourbon, which accounts for less than 1% of northbound shipments.

The Long Arc of History: Opportunities for Progress

In this section, we cleanse the palate by briefly considering opportunities for progress in the U.S.-Canada economic relationship. Once the current turbulence has passed, there is ample room for closer collaboration. Ideally, the approaching USMCA review would be only a starting point in a broader conversation about cross-border cooperation and continental prosperity.

An obvious first step would be for both sides to dismantle recently erected trade barriers and reaffirm commitment to strong bilateral trade with stable and low (ideally zero) tariffs. As part of this, it would be encouraging to see longer-standing trade irritants resolved more permanently. There is also room for both sides to reduce barriers to cross-border investment. Canada is a laggard on this front: according to the OECD, it has the third-most restrictive foreign direct investment regime of 38 member countries. The U.S. is ranked near the middle of the pack, which also leaves more to be desired.

Other steps could include reducing home bias in government procurement and further opening trade in services, for example by improving cross-border labour mobility. The beneficial hand of the free market should be allowed to operate as much as possible, but in areas where regulation may be required, it would be best to harmonize the rules (for example, in technology and AI). Perhaps most importantly, future agreements should establish a better balance between commitment and flexibility. Free trade is worth little if viewed as temporary, as businesses will be hesitant to make the types of longer-term investments that make openness beneficial. For this reason, the USMCA’s sunset clause should be abandoned.

All of these possibilities should be considered not only in an economic context, but a geopolitical one. The world has become a more dangerous place. Now, as ever, it is crucial that our countries ensure a trusting and productive relationship built upon our common values, shared geography, and intersecting histories.