Economic commentary provided by Alberta Central Chief Economist Charles St-Arnaud.
Key takeaways:
- US tariffs of 25% on all imported Canadian goods, except for energy taxed at 10%, came into effect. In response, the Canadian government announced 25% tariffs on $155bn worth of US goods to be implemented in two phases; $55bn starting today and $130bn in 21 days if the tariffs are still in place.
- The lower tariffs on energy exports means that the effective tariff rate on Canadian exports, at 20.3%, is lower than 25%. Moreover, there is some variation across provinces, with an estimated effective tariff rate of 12.7% for Alberta and 17.0% for Saskatchewan. In comparison, 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 value of 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 province 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. Nevertheless, with 15% of jobs in Alberta directly or indirectly exposed to exports to the US, the highest amongst provinces, its labour market could be widely affected.
- While lower tariffs on energy exports would suggest that Alberta will be less affected than other provinces, this is not the case, with the potential hit on GDP and employment remaining elevated.
- The big question now is: how long will tariffs be in place and what can Canada offer to have them removed? As we’ve previously written (see US tariffs: A death by a thousand cuts), there are no clear answers. What is certain is that President Trump and his advisors have suggested various reasons for imposing tariffs. These can be divided into four categories: 1) bargaining chips to extract concessions or favours from other countries, 2) means for other countries to pay for US’ services, such as its “security umbrella”, 3) to gain access to resources from? a new territory, and 4) repatriate production and investments to the US.
- Even if the current tariffs were to be paused, President Trump has announced or expressed his plan for other ways to impose tariffs that would affect imports from Canada. This includes tariffs on steel, aluminum and copper, reciprocal tariffs against any perceived unfair trading practices, tariffs on agricultural products and tariffs on car imports. Essentially, tariffs could just take another form.
- Whether tariffs are legal or not under the USMCA is completely irrelevant. This is because it would take years for the courts to provide a judgment against any unlawful tariffs and award reparation. In the meantime, some permanent changes could be made to the Canadian-US relationship, such as a permanent diversion of some production and investment to the US.
- Given 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.
- Moreover, having surged higher again in February, the extreme level of uncertainty caused by tariffs is already having a negative impact on the economy, as businesses and consumers hold back their investment and spending.
- 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 its economic impact o, 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. Hence, blanket income replacements such as those put in place during the pandemic should be avoided, especially since – contrary to the COVID shock – the shock from tariffs will be more permanent.
- Canada should respond to tariffs by significantly improving its investment attractiveness, competitiveness and productivity. Canada should also actively engage with allies to diversify its markets and invest in critical infrastructures to support trade diversification.
- The monetary policy response will likely depend on how long tariffs are in place and whether the deflationary pressures from lost input, or the inflationary pressures from tariffs themselves and a weaker Canadian dollar are more important.
- We believe that the BoC is likely to focus more on the loss of output. With this, we expect the Bank of Canada to cut its policy rate, if the tariffs remain in effect. However, the size of cuts is uncertain. Given the magnitude of the shock on the economy, it is likely that the BoC may decide to reduce its policy rate by more than 25bp and opt for a 50bp reduction and front-load the monetary support.
- The question is how low rates could go and how quickly; given slower population growth in 2025 and 2026, the neutral rate will be pushed lower (see Searching for the terminal rate).
What came into effect?
After a month of reprieve, U.S. tariffs on imports from Canada, Mexico and China announced by President Trump took effect today (see The US imposes tariffs on Canada. What’s next? for our initial take). The tariffs that are taking effect are those contained in the Executive Order signed by President Trump on February 1st, 2025. More precisely, using the International Emergency Economic Powers Act, the Executive Order announced 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 raised the tariffs on all imports from China by 10%. Moreover, the Executive order included a provision allowing for an escalation in tariffs if one country retaliates. The Executive Order impose tariffs “to address the flow of illegal drugs at the border”
The Canadian response
As announced following the signing of the Executive order a month ago, PM Trudeau announced that the 25% tariff in retaliatory tariffs on $155 billion of US goods would take effect. These tariffs are scheduled to apply in two phases.
- The first tranche of 25% tariffs will apply to $30bn of US goods taking effect immediately.
- A second tariff tranche 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.
In Ontario, Premier Doug Ford is already talking about imposing a tax on electricity exports and even cut off supply altogether.
As we wrote previously (see US tariffs: A death by a thousand cuts), while fighting back may feel satisfying and justified, Canada has a limited scope to inflict significant pain south of the border without causing self-inflicted damage at home. Whereas the US exports the equivalent of about 1.6% of its GDP to Canada, roughly 25% of Canadian GDP is exported to the US. Hence, as trade shocks would have a significantly bigger impact in Canada than in the US, any retaliatory measures Canada puts in place could end up hurting the Canadian economy more than its intended target.
Instead, Canada should respond to tariffs by significantly improving its investment attractiveness, competitiveness and productivity. Canada should also actively engage with allies to diversify its markets and invest in critical infrastructures to support trade diversification.
Who will be most affected?
The impact on the Canadian economy will be far-reaching. As we wrote before (The US imposes tariffs on Canada. What’s next?), 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 the board, it is important to consider the difference in tariff rates between the energy and non-energy sectors in assessing the impact on various regions of the country. Hence, 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.
A much lower level of effective tariffs from Alberta doesn’t mean the province 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 province that will be the least affected 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.
Employment in Ontario is by far the most exposed to US tariffs in terms of number of jobs exposed. Almost a million jobs are directly or indirectly linked to exports to the US, about 13% of all jobs in the province. However, as a share of total employment, Alberta is the most exposed with about 15.1% of jobs in the province directly or indirectly exposed to exports to the US, about 360,000 jobs in 2019, the last year data is available. However, once the structure of the tariffs is considered, because of its higher effective tariff rate, Ontario will be much more affected.
What’s next?
The big question now is: how long will the tariffs by in place and what can Canada offer to have the tariffs removed? However, as we wrote (see US tariffs: A death by a thousand cuts), there are no clear answers. What is certain is that President Trump and his advisors have suggested various reasons for imposing tariffs. These can be divided into four categories: 1) bargaining chips to extract concessions or favours from other countries, 2) means for other countries to pay for US’ services, such as its “security umbrella”, 3) to gain access to resources or a new territory, and 4) repatriate production and investments to the US.
Considering President Trump’s many reasons for imposing tariffs, viewing them solely as a bargaining chip during negotiations would be a mistake. As such, reason #3 is the reason why is constantly refers to Canada as the 51st state.
Moreover, even if the current form of tariffs were to be removed, President Trump has either signed or floated various ways to do so, each with varying degrees of impact on the country. This includes tariffs on steel and aluminum, tariffs on US imports of cars, tariffs on US imports of agricultural products, reciprocal tariffs against any perceived unfair trading practices, which would likely target Canada’s supply management of agricultural products, the GST, the digital tax, the foreign ownership threshold in some industries, and any tariffs on US goods, especially retaliatory tariffs.
This suggests that having the current tariffs removed is only the end of a battle and may not end the trade war.
Whether the tariffs are legal or not under the USMCA is completely irrelevant. This is because it would take years for the courts to provide a judgment against any unlawful tariffs and award reparation. In the meantime, some permanent changes could be made to the Canadian-US relationship, such as a permanent diversion of some production and investment to the US.
What should the policy response be?
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. 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.
Already, the extreme level of uncertainty is affecting the economy, with the “Economic Policy Uncertainty Index”, developed by Baker, Bloom and Davis[1], surging further in February to a new record. The longer uncertainty persists, the broader the impact will be on investment and the economy, businesses and consumers reduces their spending.
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, 2) type of support and who to target, 3) length of support. 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.
While some fiscal support will be required to help workers and businesses negatively affected by US tariffs, we believe the aid provided shouldn’t take the shape of blanket income replacement similar to those put in place during the pandemic; this is because the impact of tariffs is likely to be more permanent than the impact of the pandemic. In other words, there will likely be no swift rebound in the economy post tariffs.
Monetary policy
In a recent speech (see), BoC Governor Macklem explained that US tariffs could permanently lower Canadian GDP by about 2.5%, with the GDP being two percentage points lower by the end of 2025. This estimate is based on the 25% tariffs on all goods, except for 10% on energy, and includes retaliations from Canada. The BoC also estimate that inflation would rise by almost 0.7pp by early 2026, as the impact of the tariffs on prices will be more powerful in the short term than deflationary pressures coming from the decline in demand and the wider output gap.
In our view, with those estimates, 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.
If tariffs are still in effect by the time of the Bank of Canada March meeting, we expect the Bank of Canada will cut its policy rate. However, the size of the cut is uncertain. Given the magnitude of the shock on the economy, it is likely that the BoC could decide to reduce its policy rate by more than 25bp and opt for a 50bp reduction and front-load some of the monetary support.
The question for the outlook for monetary policy 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 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 2.00% before the mid-point of 2025.
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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.