Canadian Quarterly Economic Forecast

 

The world has been on the edge of its seat as President Trump feverishly implements an agenda that saw 90 Executive Orders in the first 60 days. Much of the focus thus far has been on policies that will weigh on economic growth – the dramatic cuts by Elon Musk’s DOGE to rein in government spending, and on-again, off-again tariff threats. The positive impulses are yet to come from de-regulation and tax cuts. Given the limitations to government finances, we don’t think new tax initiatives will be of a magnitude to fully lean against the complex and forced reorganization being initiated by the administration. Right now, markets are of the same view. Uncertainty on trade policy has soured sentiment among investors, sending the S&P500 into correction territory (Chart 1). Navigating uncertainty is the name of the game right now. Our global forecast is based on the U.S. tariff and other policy assumptions outlined in the text box below, which we believe balance the upside risk that tariffs will settle at lower levels, or have a shorter shelf life against some trading partners, with the downside risk that they are more punitive or longer lasting. 

It’s not just investors’ whose moods have darkened, consumer and business confidence measures have also come off highs from when Trump was first elected (Chart 2). This has occurred despite the U.S. economic data painting a resilient picture. The job market has remained solid relative to history. The unemployment rate has remained steady between 4-4.2% since last summer. Economic growth in the fourth quarter outperformed our expectations with a solid 2.3% pace. 

We would have been releasing an upgrade to our U.S. 2025 outlook if not for the confidence hit from policy uncertainty, a higher effective tariff rate on imports and greater government restraint. The slowdown in economic growth causes the unemployment rate to be slightly higher. This estimate would have been higher if not for softer labor force expansion from weaker immigration, which we expect to fall from 2+ million in 2023-24 to 500 thousand by 2026. We also pared back growth in government spending given DOGE’s aggressive cost cutting that has spending and employment knock-on effects to the private sector and non-for-profit institutions. And lastly, residential investment was downgraded due to the persistent high interest rate environment that’s made more complex by weakened confidence and a higher cost structure, as tariffs feed into nearly all aspects of home building (steel, aluminum, lumber…and all the production byproducts that include window frames, appliances and so forth). 

One of the few indicators to receive an upward revision was exactly where it’s least wanted – inflation. Our December forecast embedded an effective U.S. tariff rate of 7.5%. With the mark-up to 14% for a six month period and a gradual decline thereafter, the Federal Reserve’s key inflation gauge (core PCE) now peaks at 4.3% annualized by Q2. As a result, the Fed will have to walk a tight rope in providing some support to a weakening economy, while also being mindful of higher inflation expectations becoming embedded on a longer term basis. We expect only two rate cuts with a return to our neutral rate assumption of 3% delayed until next year. 

Canada – Knock-Knock-Knockin’ on Recession’s Door

Canada has borne the brunt of President Trump’s tariff action despite having one of the most equal trade relationships of any  country (Chart 3).  This leaves us skeptical that tariffs can be avoided no matter the negotiation tactic. A wave of “Buy Canada” national pride has been unleashed, but it won’t be sufficient to offset the direct negative impacts to the outlook. As outlined in the text box, our forecast assumes a high level of U.S. tariffs remain in place for six months, before being gradually reduced through negotiations. However, even with this, we doubt Canada’s trade and tariff relationship will return to the pre-Trump state. We expect Canada’s economy to tip into a shallow recession this year, mitigated in part by government support. The Canadian government has been swift acting in announcing changes to the work-share program for impacted industries, in addition to broad financial programs operated by the EDC, BDC and Farm Credit Canada. 

Tariff threats have sent a chill through Canada’s housing market, and downside pressure will build under the added weight of higher materials costs from a weaker Canadian dollar and retaliatory tariffs. We expect residential investment to contract through much of this year. That chill will also spread to broader business investment and consumer spending, with outlays forecast to decline through the spring and summer. However, the overall contraction in economic activity is less than seen in a typical Canadian recession.

Weaker demand is likely to tip Canada’s job market into net job losses in the third quarter. But the unemployment rate rises only marginally, as slower labour force growth creates a powerful counterforce. Under Canada’s recent immigration policy shifts (see report), the labour force grinds to a halt in the second half of 2025. The unemployment rate is forecast to rise to a peak of 7%. This too is less than typically seen in a recession. This is an outcome of the past two years having already pressured the unemployment rate higher (1.8 percentage points) due to massive growth in the labour force. This influence will quickly recede. Had it not been for the economic downdraft created by the U.S., we estimated that the Canadian unemployment rate would have floated down to 5.9%, but that’s yesterday’s news.

We hope we are wrong, and that our assumptions prove pessimistic. If that is the case, the economy is likely to avoid the recession forecast. Before the threats began, Canada’s economy was reflecting a cyclical upswing, with lower interest rates starting to boost housing. The sales tax holiday and stimulus payments were providing an additional boost to consumer spending. In the first quarter, the data will likely show a consumer kissing up against the 3% mark on growth. 

That first quarter data will provide a head fake. Consumers will likely shift to a cautious stance thereafter and the trade balance will be heavily exaggerated by businesses front-running U.S. tariffs. This will lead to a ramp up in exports, with net trade expected to contribute nearly a full percentage point to first quarter growth. 

Like the U.S. narrative, Canadian inflation is expected to run a bit hotter than in our last forecast due to retaliatory tariffs and a weaker loonie. This puts the Bank of Canada in a tough spot. So far, the Bank has been willing to cut interest rates to support domestic demand. But there will be limits on how low it can go. Interest rates won’t be able to heal what ails the economy, and inflation expectations needs to be carefully managed. We believe the overnight rate could reach 2.00 to 2.25%, limited by inflation pressures. That will widen the gap with the U.S. policy rate to two full percentage points (200 bps) – the widest since the late 1990s. This is expected to push the loonie to around the 67 cent U.S. range through the middle of the year, which will provide some cushion to exporters, and likely keep more Canadian spending at home. 

Trump Spurs Global Policy Action

Overall, global growth has been downgraded this year and next. U.S. tariff risks are depressing sentiment, affecting most major trading economies. One of the biggest changes to our forecast resides within Europe. Germany is expected to deliver a fiscal U-turn, increasing infrastructure spending and looking to exempt defense spending (above a threshold) from their debt limits to enable higher levels of military expenditures (see table). Given typical lags in getting money out the door, the boost isn’t expected to show up until late-2025. In the rest of the European Union, the uptake on newly allocated funds for defense spending presents an upside risk to the outlook and is not currently incorporated due to the lack of details. 

China has seen the biggest actual increase in U.S. tariffs to an additional 20%. And yet, it recently established a “roughly” 5% growth target for this year, which includes increased government stimulus. Given the headwinds to the economy and ongoing structural issues, it remains to be seen whether the proposed stimulus measures will be sufficient to meet the growth target. As in 2024, if growth is seen as falling short, there will likely be more ad hoc spending measures to support the economy.