North American Outlook

June 10, 2025 | 08:32

Trade Wars: Episode XI

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

Despite some progress in rolling back tariffs and dialing down trade tensions, the outlook for the trade war remains cloudy.
Canada's economy still faces a mild downturn as exports to the U.S. contract, though growth should resume once the tariff clouds part.
Tariffs and uncertainty are starting to erode the U.S. economy's resilience.
The Bank of Canada and the Federal Reserve are likely to resume rate cuts once economic damage from the trade war becomes evident.
The Canadian dollar appears to have turned a corner against a weakening U.S. dollar.

Canada

Don't count the Canadian economy out just yet. It surprised to the upside in the first quarter, expanding at an annualized rate of 2.2%—marking the fifth consecutive quarter of above-potential growth. However, this strength largely reflected businesses and exporters rushing to beat tariffs, effectively borrowing activity from future quarters. Meanwhile, consumer spending slowed and residential construction plunged, as trade-related fears sapped confidence. Despite lower mortgage rates, existing home sales fell for a fifth straight month in April, though preliminary May data from several cities suggest the market may be stabilizing. In Southwestern Ontario and British Columbia, housing affordability remains an issue despite some improvement. Buyers are holding back, concerned about overpaying and potential job losses.

Despite stronger Q1 results and a modest gain in preliminary April GDP, the economy appears poised for a mild contraction in the near term. The goods trade deficit tripled to record highs in April amid a sharp drop in exports to the U.S.—the same month new duties on motor vehicles took effect. Meanwhile, trade-related uncertainty is expected to weigh on business spending. The auto industry has already announced layoffs, and further cuts in steel and aluminum are anticipated. Since January, businesses have shed 15,000 jobs, led by four straight monthly declines in manufacturing. The unemployment rate rose 0.4 percentage points during this period to 7.0%—the highest since 2016 excluding the pandemic—and is projected to reach 7.7% by year-end. Also, sharp cuts to immigration could dampen consumer spending and housing activity.

Still, the outlook has brightened somewhat. The average effective tariff rate on Canadian shipments to the U.S. is around 6%—lower than the 10% baseline rate for most countries and well below China's levy. This rate primarily reflects 50% duties on steel and aluminum and 25% levies on the non-U.S. content portion of motor vehicles. Other goods that comply with the USMCA's rules of origin remain duty-free and constitute the vast majority of exports. Another positive development is that high-level trade talks involving Prime Minister Carney and President Trump are already underway. This could result in some rolling back of tariffs and greater clarity on future trade policies—even before formal talks to revamp the free-trade agreement begin—unleashing some pent-up demand from businesses and homebuyers. Progress in the trade war and some firmer data led us to raise our 2025 real GDP forecast modestly to 1.3% (or 0.5% on a Q4/Q4 basis).

The economy is expected to strengthen further in 2026, growing at an above-trend rate of 1.9% on a Q4/Q4 basis, which should pull the jobless rate down to 7.2% by year-end. In addition to lower interest rates, growth will benefit from increased federal spending on transportation infrastructure, housing development, and defence, and on industries harmed by tariffs. Initiatives to fast-track major energy and mining projects and eliminate provincial trade barriers will also provide support, as will a moderate decline in personal income taxes. While the housing market could remain weak in the near term, a recovery is expected to unfold once mortgage rates decline further and economic concerns fade. This could reverse recent declines in home prices in Ontario and British Columbia.

Canadian regions face differing challenges from the trade war. Ontario, with its heavy reliance on the auto and steel industries, is expected to grow just 0.9% in 2025. It also has the weakest housing market in the country, compounded by a surplus of unsold condos in Greater Toronto. Aluminum-dependent Quebec may be hit even harder, with projected growth of just 0.7%. At the other end of the spectrum, Alberta’s economy is likely to outperform with 2.1% growth, thanks to strong sales of duty-free oil to U.S. refiners and healthy in-migration from other provinces.

Lower oil prices and the removal of the consumer carbon tax slashed annual CPI inflation to just 1.7% in April, though some core measures are running closer to 3%, possibly due to counter tariffs and disrupted supply chains. But rising unemployment will ease price pressures, keeping inflation close to the 2% target this year and next.

Trade uncertainty and persistently high core inflation have kept the Bank of Canada on hold since March, following seven consecutive rate cuts. Like the Fed, the Bank is waiting for the data to confirm that tariffs are harming the economy. We sense that rising unemployment and softer core inflation will prompt the Bank to resume easing in July, with projected cuts totalling 75 basis points by early next year. With the Bank currently on ice and the U.S. dollar playing defence, the Canadian dollar has appreciated to eight-month highs of 73 cents (US). We see it rising another penny by year-end and similarly in 2026, assuming both trade tensions and the Fed ease through next year.

United States

Actions to avoid tariffs make it difficult to assess the true health of the U.S. economy, though signs point to a slowdown. Real GDP contracted at an annualized rate of 0.2% in Q1, as a surge in imports and cuts in federal spending more than offset front-loaded purchases of business equipment and motor vehicles. With new tariffs in place, imports, investments, and autos are now reversing course. Nevertheless, the pullback in imports should dominate, lifting real GDP by 1.7% in Q2—a notable revision from our earlier call of near-flat growth. The upgrade reflects the rolling back of some reciprocal tariffs and an attendant rebound in financial conditions. The average effective tariff rate on U.S. imports is now approximately 15%—still six times higher than pre-trade war levels, but down from a peak of 26% when China's new tariffs stood at an eye-popping 145% (30% currently). Meanwhile, investor sentiment has improved significantly since the Liberation Day shock. After flirting with a bear market, the S&P 500 is now within 2% of its February 19 peak, supporting a partial rebound in consumer confidence. While labour market conditions have softened, the unemployment rate remains low at 4.2%, and monthly payroll gains have averaged a decent 127,000 since the trade war began in February (though this is down from 185,000 in the prior four months).

We also raised our growth forecast for the second half of the year and now expect real GDP to expand 1.5% in 2025. However, this is nearly half last year's rate, and growth of just 1.0% on a Q4/Q4 basis could lift the unemployment rate to 4.8% by early next year. Assuming trade tensions ease and Congress passes a budget bill to reduce taxes on overtime pay, tips, and Social Security benefits, and reinstate the full immediate expensing of the cost of some production facilities, growth should improve to 1.7% on a Q4/Q4 basis in 2026.

Cheaper fuel helped annual CPI inflation fall to a four-year low of 2.3% in April. The core rate (excluding food and energy) is running higher at 2.8%, but is also near four-year lows. While tariffs have made little impression so far, they are expected to push inflation above 3% later this year. Still, barring new levies, a moderating trend should resume next year amid looser labour market conditions.

Unclear about whether tariffs will affect inflation more than growth, the Fed appears content to hold to the sidelines until the economy shows clearer signs of weakness. We recently pushed back the timing of the next rate cut to September and now forecast just two trims this year, although we still anticipate a total of 150 basis points of rate declines before the end of next year.