North American Outlook

May 06, 2025 | 09:28

Trading Down

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

We assume a recent lull in the trade war will set the stage for a partial rollback of some tariffs, but not before economic casualties mount on both sides of the border.
Canada's economy still faces a shallow downturn as exports to the U.S. contract, but the expansion should resume later this year as clarity emerges on tariffs. The U.S. economy will nearly stall for a while.
The Bank of Canada and the Fed will look past higher inflation and focus on a rising jobless rate, reducing policy rates three more times this year by a total of 75 basis points.

Canadian Economy

After gaining momentum in the second half of last year on falling interest rates, Canada’s economy now likely faces a shallow downturn as a result of the trade war. While most Canadian goods sold to the U.S. comply with the USMCA and are duty-free, this is not the case for steel and aluminum products, as well as the non-U.S. portion of finished motor vehicles, which face a 25% duty. These tariffs could drive exports sharply lower this spring and summer. Layoffs have already been announced by several automakers, including at GM’s Oshawa plant. Uncertainty about trade policies is already undermining consumer and business confidence. Supply chain disruptions and a less efficient allocation of resources will hinder productivity. Sharp cuts to immigration will also weigh on consumer spending and housing market activity. As a result, after healthy 2.6% annualized growth in the final quarter of last year, real GDP likely slowed to 1.5% in the first quarter and is expected to contract modestly in the second and third quarters. Annual growth is expected to slow to just 0.7% in 2025, down from 1.5% in 2024. Ontario, with its significant exposure to the auto and steel industries, will likely suffer the most with expected annual growth of just 0.1% this year.

On a more positive note, Canada was spared both reciprocal and baseline tariffs on "Liberation Day". Moreover, levies on motor vehicles exclude the portion made in the U.S.A., effectively cutting the 25% duty in half. More recently, the White House announced that USMCA-compliant auto parts from Canada (and Mexico) would be exempt from levies for at least two years. As a result, the average effective tariff rate on Canadian exports to the U.S. is estimated at around 5%—much less than feared going into the trade standoff in early February. Of course, tariffs could change abruptly (the President recently threatened to impose 100% duties on foreign-made films, which would be a major blow to the Toronto and Vancouver movie industries). However, assuming trade talks succeed in rolling back some duties, the economy should resume expanding later this year, registering 1.0% annual growth in 2026 (and a trend-like 1.8% on a Q4/Q4 basis). Growth will also benefit from expansionary fiscal policies. The re-elected Liberal Party ran on a platform of increased spending, modest personal income tax cuts, and larger deficits on the order of 2% of GDP this year, compared with a previous baseline of just over 1%.

Longer term, Canada's economic growth will be influenced by how successful government policies are in attracting capital inflows and business investment, removing internal trade barriers, and helping exporters diversify away from the U.S. and toward other regions. Some of these policies could come at the cost of a larger budget deficit, potentially necessitating higher taxes and cutbacks to public services later on—thereby lowering the country’s long-run growth potential.

Canada's labour market has yet to show significant strain from the trade war, but this may be the proverbial calm before the storm. While employment fell in March, it is still up 1.7% over the past year. The jobless rate rose from 6.1% to 6.7% in the past year, though largely due to rapid labour force growth driven by unsustainable immigration flows. The expected economic downturn could lead to widespread job losses—potentially exceeding 100,000 workers—raising the unemployment rate to 7.7% by year-end.

Weaker demand and layoffs will help extinguish any inflation sparks ignited by retaliatory tariffs. Inflation has been volatile due to recent temporary changes in sales taxes, but the annual CPI rate remained low at 2.3% in March and is expected to fall further in April due to the elimination of the carbon tax and falling fuel prices. Several core indices suggest that underlying inflation is running modestly above the headline rate, partly because of inertia in rents and mortgage payments. Counter tariffs on some U.S. imports will temporarily lift inflation, but the annual rate should still hover around the 2% target this year and next, given lower energy costs and rising unemployment.

Central banks dislike stagflation for a reason. After cutting policy rates seven straight times, and by a total of 225 basis points since last summer, the Bank of Canada adopted a more cautious stance in April due to tariff-related uncertainty, opting to keep rates steady at 2.75%. However, by taking a reactive approach, the Bank risks falling behind the recession curve. We expect it to swing into action at the June meeting, cutting rates three more times this year by a total of 75 basis points, as the unemployment rate rises.

U.S. Economy

The resilient U.S. economy has lost some momentum, largely due to trade war concerns. A tenfold increase in the average effective tariff on U.S. imports—to around 25%—is expected to significantly reduce growth this year. Real GDP contracted at a 0.3% annualized rate in Q1 due to a surge in imports aimed at avoiding tariff hikes, as well as cuts in federal government spending. This import surge could continue in Q2 ahead of reciprocal duties on more than 55 countries potentially taking effect on July 9. Meanwhile, retailers may face inventory shortages as ocean container bookings from China have plummeted due to the 145% levy on imports. In addition to weaker U.S. exports to China and Canada owing to retaliatory levies, the economy will suffer from supply chain disruptions, diminished consumer spending power, increased policy uncertainty, and deteriorating financial conditions (though much of this has been walked back by the recent rally in equity markets). Some manufacturers are benefiting from increased orders as firms seek to avoid tariffs, but their input costs are also rising. Moreover, large-scale federal layoffs and spending cuts could further weaken the economy—at least until Congress passes a bill to lower corporate and other taxes, albeit at the expense of a growing budget deficit. Annual GDP growth is projected to average 1.1% in 2025, down from 2.8% in 2024. However, assuming tariffs, especially with China, are rolled back meaningfully, economic growth should improve modestly to 1.3% in 2026.

Employment growth has moderated but remains healthy with nonfarm payrolls rising by 177,000 in April and up 1.2% over the past year. However, large layoff announcements by the federal government (amounting to roughly 10%), coupled with hiring freezes in an anxious private sector, could lead to a material slowdown in job creation. Indeed, layoff announcements outside the government rose sharply in April. While the unemployment rate remains low at 4.2%, it is projected to increase to 5.0% by year-end.

Thanks to lower fuel prices, the annual CPI rate fell to 2.4% year-over-year in March from 2.8% in February. The core rate (excluding food and energy) stands at a four-year low of 2.8%. However, this could mark the nadir for a while. Tariffs are expected to push inflation toward 4% later this year, before a moderating trend resumes in response to weaker demand and softer labour market conditions.

Faced with unprecedented uncertainty, the Fed will likely delay interest rate cuts for several more months. Chair Powell has stated there is no urgency to ease policy further, as the economy remains solid and inflation is still somewhat elevated. Nonetheless, assuming tariffs do not alter long-run inflation expectations, policymakers will likely respond to rising unemployment by cutting rates a cumulative 150 basis points between July 2025 and June 2026.