North American Outlook

March 17, 2025 | 08:45

Tariff Torrent

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

Canada's economy will suffer serious, though not life-threatening, wounds in the first major assault of the trade war. A two-quarter recession is expected before growth resumes.
The U.S. economy will not be unscathed, with annual growth expected to drop below 2% for the first time in five years.
The Bank of Canada will likely focus more on rising unemployment than higher inflation, lowering rates by a further 75 basis points.
The Fed will need to walk a policy tightrope to balance uncertain inflation and growth risks, but will likely resume easing in September.

Canadian Economy

The shelf life of economic forecasts is now measured in days, even hours, due to the U.S. Administration’s unpredictable trade policies. Uncertainty alone is harming investment, especially in Canada given its elevated exposure to trade. For now, we assume that the tariffs imposed on Canadian exports to the U.S. on March 4, though partially deferred until April 2, will remain in effect for one year. These include 25% duties on most goods and 10% levies on energy products, critical minerals and potash. Canada has pledged to retaliate with 25% duties on about a third of American exports. The combined levies could result in the Canadian economy contracting for two quarters, reducing real GDP growth by 1.5 percentage points this year to just 0.5%. That's a material setback following middling 1.5% gains in the previous two years. Our view contrasts with the consensus call, which remains above 1% this year, though ripe for downgrade on April 2.

Before tariffs became a reality, the economy had a decent chance of picking up to a near-2% rate this year. It was gaining momentum on lower interest rates, with consumer spending and residential construction powering real GDP to a 2.6% annualized increase in Q4 (and 2.4% year-over-year). A partial sales-tax holiday and Ontario's rebate cheques helped, but an upturn in consumer credit growth suggests that lower interest rates were the primary driver. This implies some upside growth risk should the President's tariff threats prove more bark than bite.

The expected economic downturn could lead to more than 100,000 net job losses (-0.5%) and push the unemployment rate to 8.0% by year-end, up from 6.6% in February. More than 387,000 jobs (+1.9%) were created in the past year through February, reflecting the economy's tailwind before the tariff storm.

Counter tariffs, together with a weakening Canadian dollar—it's expected to fall to 67 cents US (C$1.49) by September from just under 70 cents currently as interest-rate spreads with the U.S. widen further—could push CPI inflation to 2.7% in the months ahead. However, this spike won't last long if the jobless rate rises further, and inflation should return to around the current rate of 1.9% by next spring.

The Bank of Canada has lowered policy rates by 225 bps since last June to 2.75%, the middle of the neutral range. After trimming rates by 25 bps on March 12, it warned that further moves would depend on whether tariffs have a more adverse effect on growth than on inflation. We believe the Bank will look past the temporary inflation rise and focus on protecting workers and businesses in this "new crisis" (Governor Macklem's words), and will trim rates at the next three meetings.

With the U.S. Administration threatening "economic force", Canada faces an unprecedented level of risk. Duties of 25% on U.S. imports of steel and aluminum from all countries, which took effect on March 12, will have a modest impact on aggregate growth and inflation. However, they could have severe repercussions for both industries—especially steel, which the U.S. is less dependent on than imported aluminum. Potential reciprocal tariffs and industry-specific duties on April 2 could amplify the damage, prolonging and deepening the expected recession. The motor vehicle industry would be decimated in a worst-case scenario.

All of this drama is happening as the country heads into a possible spring federal election. Whichever party wins will need to both backstop affected workers and businesses and ensure that Canadian companies remain competitive with U.S. firms that stand to benefit from lower U.S. corporate taxes and reduced regulation.

U.S. Economy

Though much less exposed to trade than Canada or Mexico, the U.S. economy will experience more than just flesh wounds in a trade war. We lowered our 2025 Q4/Q4 GDP growth outlook by 0.6 percentage points in response to the announced tariffs on Canada and Mexico, as well as the already-imposed 20% levy on China. On an annual basis, GDP growth could slow to 1.8% in 2025 from 2.8% last year, marking the weakest performance in five years. Tariffs, a regressive form of taxation, will disproportionately impact lower-income households. Widespread layoffs of federal government workers will exacerbate the pullback in spending. Business surveys indicate that investment has already been delayed due to trade uncertainty. The unemployment rate, which has steadied in recent months, is expected to rise to 4.5% by year-end from 4.1% in February. It could rise further if substantial new levies are announced in early April.

Beyond an escalating trade war, the U.S. economy faces a separate threat from a correction in equity markets, with major indexes recently falling 10% from their peak. Investors have long feared that a trade war could overshadow the administration's pro-growth policies—in particular, lower taxes on corporations, overtime pay, tips, and Social Security benefits, as well as lighter regulation. But with tariffs taking centre stage, recession fears are growing. If equity markets decline further, the wealth effect will reverse, dragging consumer spending down with it.

Congress is still in the early stages of passing a budget for the next fiscal year, beginning October 1. The House's initial bill focused heavily on spending cuts while leaving limited room for new tax reductions beyond extending the 2017 individual tax cuts. Senate Republicans are working to include additional tax cuts, but this may require more spending restraint to prevent the budget deficit from spiraling out of control. Ultimately, fiscal policy could be less stimulative than previously expected.

With inflation holding above target but edging lower, the last thing the Fed needs is a stagflation shock—of which tariffs are a prime example. Inflation was already poised to moderate further as looser labour market conditions slowed wage growth. That, combined with decent productivity gains (2.0% year-over-year in Q4), allowed unit labour costs to cool to a 2.0% annual rate, consistent with price stability. However, tariffs will at least temporarily push inflation higher, making it difficult for the Fed to assess the underlying trend. As Chair Powell remarked, the Fed does not need to rush into further easing, particularly given the murky outlook for trade, immigration, regulation, and fiscal policies. We maintain that the Fed will likely resume rate cuts in September as the jobless rate edges higher, lowering rates by 125 basis points through 2026. However, the extreme uncertainty also increases the risk of a policy misstep, where the Fed may need to address stubborn inflation at the expense of growth. In this event, the soft landing the Fed worked hard to engineer may become the greatest casualty in the trade war.