The US imposes tariffs on Canada. What’s next?

Economic insight provided by Alberta Central Chief Economist Charles St-Arnaud.

Key takeaways:

• Over the weekend, US President Trump announced 25% tariffs on all imports from Canada and Mexico, except for energy imports from Canada, which will face a 10% levy.
• In response, the Canadian government announced 25% tariffs on $155bn of US goods to be implemented in two phases.
• Mining, oil and gas, and manufacturing sectors in Canada have the most direct exposure to US exports and will be the most severely impacted. However, other industries such as agriculture, fishing, transportation, wholesale trade, and professional, scientific and technical services will also be significantly impacted.
• The lower tariffs on energy exports mean that the effective tariff rate on Canadian exports is lower than 25% at 20.3%. Moreover, there is some variation across provinces, with an estimated effective tariff rate of 12.7% for Alberta and 17.0% for Saskatchewan, while it will be almost 25% for Ontario (24.8%), Quebec (24.3%) and BC (22.0%) despite their electricity exports.
• However, this doesn’t mean Alberta will be the least affected province. We can estimate the cost of the tariffs as a share of GDP in Alberta at 4.1% per year. As a comparison, the cost will be about 4.6% of GDP for Canada and 6.3% for Ontario; the least affected will be Newfoundland at 2.3%.
• When it comes to employment, we find that jobs in Ontario, Quebec, and New Brunswick are at highest risk from US tariffs.
• While the lower tariffs on energy exports would suggest that Alberta would be less affected by the tariffs than other provinces, this is not the case, with the potential hit on GDP and employment remaining elevated.
• The main uncertainty is whether the US will escalate the trade war by increasing tariffs on Canada and how long the tariffs will be in place.
• Given the various estimates of the impact of the tariffs on the economy, it is very likely that the Canadian economy is headed toward a recession in 2025. There is a risk that knock-on effects could exacerbate the impact of the tariffs on the economy, especially if job losses become important.
• Since tariffs are a negative supply shock on the economy, i.e. they reduce economic activity and lead to inflation in the short term, fiscal policy may be a better tool to mitigate the impact on the economy, especially since it can be better targeted at sectors/regions needing support.
• However, there is a risk that any fiscal package focuses too much on supporting demand and not enough on improving the supply side of the economy and productivity. As such, any fiscal support should also include investment in infrastructure and support for enhancing Canada’s access to other markets.
• The monetary policy response will likely depend on how long the tariffs are in place and whether the deflationary pressures from lost input or the inflationary pressures from tariffs themselves and the weaker Canadian dollar are more important.
• We believe the BoC is likely to focus more on the loss of output and cut its policy rate further. The question is how low rates could go and how quickly; given the slower population growth in 2025 and 2026, the neutral rate will be pushed lower (see Searching for the terminal rate).
• We expect the Bank of Canada to cut its policy rate at the March meeting; given the size of the shock on the economy, the BoC could decide to reduce its policy rate by more than 25bp. Similarly, given its next meeting is scheduled in five weeks, we see a possibility that the central bank could decide to act before the March meeting with an inter-meeting emergency cut.  

After weeks of warning and uncertainty, US President Donald Trump put his threat to execution and announced tariffs on imports from Canada, Mexico and China.

What has been announced

President Trump issued an Executive Order, using the International Emergency Economic Powers Act, an executive authority that allows the President to respond to emergencies through economic means, to apply 25% tariffs on all imports from Canada and Mexico, except for energy imports from Canada which will face a 10% levy. In addition, the Executive Order also raises the tariffs on all imports from China by 10%. Moreover, the Executive order includes a provision allowing for an escalation in tariffs if one country retaliates.

The response from the Canadian government

Shortly after the announcement of tariffs by President Trump, PM Trudeau held a press conference announcing a 25% tariff on $155 billions of US goods. These tariffs are scheduled to apply in two phases.

1. The first tranche of 25% tariffs will apply to $30bn of US goods as of Tuesday, February 4th.
2. A second tranche of tariff would be levied on $125bn of goods in 21 days to allow Canadian firms time to adjust and find alternatives.

A long list of items will be subject to these retaliatory tariffs including alcohol, fruit and fruit juices, vegetables, clothing, appliances, furniture, materials, plastics, military gear, etc. Some goods targeted by tariffs were chosen to put pressure on specific states where key US lawmakers reside.

In addition to import tariffs on US goods, PM Trudeau also mentioned that non-tariff measures are also considered, like changes to procurement programs and maybe curtailing access to some critical minerals. Restrictions on oil and gas exports are not part of the response, at least for now. While the option remains on the table, the PM also said that “we will not be pursuing measures that further divide the country” and suggested that no region of the country must bear a disproportionate share of the burden of retaliation.

Some provinces have also come up with their own retaliations, such as removing alcohol imported from the US from the shelves of government-owned liquor stores, excluding US firms from the provincial procurement process, and cancelling contracts with US firms.

Who will be most affected?

The impact on the Canadian economy will be far-reaching. The mining, oil, and gas, and manufacturing sectors have the most direct exposure to US exports. However, other industries such as agriculture, fishing, transportation, wholesale trade, and professional, scientific and technical services will also be severely impacted.

However, because the tariffs are not flat across industries, it is important to take into account the difference in tariff rates between the energy and non-energy sectors in assessing the impact on various regions of the country. Hence, the actual exposure to US tariffs is not simply the share of US exports in GDP.

As such, we estimate that the effective tariffs on Canadian exports will be 20.3%. This is because slightly more than 30% of Canada’s exports to the US are energy exports. Similarly, provinces where a greater share of their exports to the US are energy exports will see a lower effective tariff rate, while the others will see an effective tariff rate much closer to 25%. As a result, we estimate the effective tariff rate for Alberta at 12.7% and 17.0% for Saskatchewan, while it will be almost 25% for Ontario (24.8%), Quebec (24.3%) and BC (22.0%) despite their electricity exports.

However, this doesn’t mean Alberta will be the least affected province. We can estimate the cost of the tariffs as a share of GDP in the province at 4.1% per year. As a comparison, the cost will be about 4.6% of GDP for Canada as a whole, 6.3% for Ontario, 5.6% in New Brunswick and 4.9% in Quebec. The least affected province will be Newfoundland at 2.3%. This is due to its low effective tariff rate (14.4%) and share of US exports in GDP (15.6%).

When it comes to employment, once we consider the effective tariff rate, we find that jobs in Ontario, Quebec and New Brunswick are the most at risk from the US tariffs, while jobs in Newfoundland could be the least at risk. As such, Statistics Canada estimates that about 1.2 million Canadian jobs are directly linked to exports to the US, 2.5 million if we include indirect exposure.

What to expect going forward?

The situation remains highly uncertain, and there are many unknowns, such as whether the Trump Administration will escalate the situation, given his threat of raising tariffs if other countries retaliate, how long the tariffs will stay in place and whether there is something Canada can offer to reverse the situation.

The Executive Order cites border issues (fentanyl and illegal immigration) as the main reasons for the need for tariffs. However, the backgrounder to the decision released by the White House refers to the trade balance and makes the national emergency look like an excuse to impose tariffs. Nevertheless, whether the US Administration has a case to impose tariffs may be completely irrelevant. By imposing tariffs, a significant restructuring can be initiated, leading to permanent damage to Canada’s export sector, even if temporary, as businesses may reconsider their investment plans in Canada.

The fact that energy imports are subject to lower levies, despite being the main source of the US trade deficit vis-a-vis Canada, suggests that a desire to rebalance bilateral trade is not the main reason for the tariffs.

Many expect that the tariffs are a negotiation tactic to extract significant concessions from Canada, whether on border security, military spending, etc. However, it may not be and could be why President Trump has repeatedly said that there is nothing Canada can do to avoid tariffs.

In a recent paper, Stephen Miran, President Trump’s pick to head the Council of Economic Advisors, suggests that the Trump administration should use tariffs to restructure the global trading system and bring back some of the industrial base to the US. Moreover, tariffs are seen as a means to force Western democracies to pay for the privilege of being protected by the US security umbrella and to level trading relationships when partners have better access to US markets than the US has to theirs. The paper also makes a case that, in some narrow cases, this can be done at little cost to the US economy.

Following this logic, tariffs against the European Union are likely the next step and it may be a matter of weeks before tariffs are levied on other trading partners. It also suggests that tariffs on Canadian goods are likely to be in effect for a long period of time.

Impact on the outlook

Various estimates of the impact of tariffs have shown that 25% tariffs on US imports from Canada would significantly impact the Canadian economy. The impact on GDP is estimated to be between 2% and 4%, depending on the assumptions, elasticities and duration of the shock used.

As an example, the Bank of Canada’s estimates published in the latest Monetary Policy, which looks at the impact of a 25% increase in US tariffs and similar retaliation by trading partners, find that Canadian GDP will be reduced by between 3.4% and 4.2% relative to their base case, with most of the impact felt during the first two years following the shock.

Given the magnitude of the shock, it is very likely that the Canadian economy will experience a recession, leading to layoffs and a rise in unemployment.

As shown previously, the manufacturing sector and provinces where the manufacturing sector represents a high share of economic activity are expected to be most affected. On the flip side, the resources sector, especially the energy sector with lower levies, may be somewhat more resilient because of the lack of substitutes in the short term. Ontario is more vulnerable than other provinces, while Alberta may be slightly less vulnerable despite its heavy reliance on exports to the US.

There is a risk that knock-on effects could exacerbate the impact of the tariffs on the economy, especially if job losses become important. As we have highlighted on many occasions (see Will it be a hard landing or a soft landing? The labour market will decide), the Canadian economy, especially households, has shown a lot of resilience since the BoC started increasing its policy rates in early 2022 mainly because the labour market has remained robust, especially when it comes to employment. The lack of layoffs has meant that there hasn’t been a shock to household income, allowing struggling households to adjust to higher interest by lengthening the amortization period of their loans or restructuring their borrowing.

Job losses due to tariffs could rapidly change this situation. First, it would reduce demand in other industries, especially those depending on discretionary spending, and exacerbate the confidence and sentiment channel. Second, given the level of household indebtedness and debt-service ratio, it would likely lead to greater household financial stress and could lead to a sharp rise in defaults. As we have mentioned, a rise in default could impact the housing market and financial institution’s willingness to lend, reducing credit availability for households and businesses potentially exacerbating the recession.

The tariffs are likely to be inflationary in the short term. However, the longer-term impact on inflation is more uncertain. The tariffs will cause both inflationary and deflationary pressures in the Canadian economy. The loss of input, increased excess supply in the economy and the rise in the unemployment rate will be deflationary. On the flip side, the depreciation in the Canadian dollar, while modest so far, the counter-tariffs and the reduction in efficiencies, as producers restructure their operations, will lead to higher import prices and could prove inflationary.

What should the policy response be?

Tariffs are a negative supply shock on an economy, reducing growth and generating inflationary pressures. This is very similar to the impact of the supply chain disruptions during the pandemic. However, tariffs also induce a demand shock, as exports are likely to ease, and weaker economic activity leads to job losses.

The appropriate response will likely depend on which shock is more important: supply vs demand. As we saw in the post-pandemic recovery, monetary policy is not the most efficient tool to deal with a negative supply shock, meaning fiscal policy is more adapted to the situation than monetary policy. Moreover, the longer the tariffs are in place, the more structural and permanent damage will be done to the bilateral trade relationship and the economy.

Fiscal policy

Fiscal policy is likely to be a more effective response, as it can be targeted. Beyond the automatic stabilizers, like employment insurance, the government will need to consider three factors:

1. Size of the support: the likelihood of a severe recession suggests that significant support may be required. However, the federal government is starting with a deficit and is close to breaking its own fiscal anchor, thereby reducing the likelihood of a large fiscal package. Moreover, given the already inflationary nature of the shock, too much support for the economy could add to these pressures and complicate the BoC’s task.
2. Type of support and who to target: contrary to the pandemic, which saw a shock affecting the economy more broadly, the impact of tariffs will be more centred on industries and regions that depend heavily on exports to the US. Measures that are targeted at those most affected by the tariffs may be preferred.
3. Length of support: the design of the support may need to keep in mind that the tariffs could be in place for a long period and lead to permanent changes in our economy. Hence, it may be essential to balance the need for forceful support actions in the short term with the need for long-term support to reorient our resources toward other sectors.

There is a risk that any fiscal package focuses too much on supporting the demand side of the economy and not enough on improving the economy’s supply side and productivity. As such, any fiscal support should also include investment in infrastructures and support to develop Canada’s access to other export markets.

Monetary policy

As the BoC explained in its latest policy decision, the appropriate monetary response will depend on how long the tariffs are in place and whether the deflationary pressures from lost input, or the inflationary pressures from tariffs themselves and the weaker Canadian dollar are more important.

In our view, the BoC will lean toward providing support to the economy. As such, we believe that the BoC will take the view that the inflationary impact of tariffs will mainly be short-lived because it is a one-off jump in prices, not a constant increase in prices. This means it will only temporarily push inflation higher unless the shock de-anchors inflation expectations or changes businesses’ pricing behaviour.

With the impact on inflation viewed as temporary, the BoC is likely to focus on the loss of output, which will be deflationary over the next two years.

The question is how low interest rates could go and how quickly. As we have shown (see Searching for the terminal rate), lower population growth in 2025 and 2026 will push potential growth and the neutral rate lower. This means that the policy rate level could still be restrictive at the lower bound of the BoC estimated range for the neutral rate. Hence, it is likely that the BoC could bring its policy rate below our current expectation of 2.00% in the second half of 2025.

Moreover, we expect the Bank of Canada to cut its policy rate at the March meeting. However, the size of the cut is uncertain. Given the magnitude of the shock on the economy, the BoC could decide to reduce its policy rate by more than 25bp. Similarly, given that its next policy meeting is scheduled for six weeks, we see a possibility that the central bank could decide to act before the March meeting with an inter-meeting emergency cut.

 

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Independent Opinion

The views and opinions expressed in this publication are solely and independently those of the author and do not necessarily reflect the views and opinions of any organization or person in any way affiliated with the author including, without limitation, any current or past employers of the author. While reasonable effort was taken to ensure the information and analysis in this publication is accurate, it has been prepared solely for general informational purposes. There are no warranties or representations being provided with respect to the accuracy and completeness of the content in this publication. Nothing in this publication should be construed as providing professional advice on the matters discussed. The author does not assume any liability arising from any form of reliance on this publication.