The Weekly Bottom Line: Tariffying – Action Forex

Canadian Highlights

• President Trump continues to threaten Canada with a 25% tariff on its U.S. exports as early as Saturday. A prolonged U.S.-Canada trade skirmish could dampen growth significantly and lift inflation.
• The Bank of Canada cut its policy rate by 25 basis points this week, bringing it to 3.0%. A trade battle would likely warrant more rate cuts than we built into our December baseline.
• The November GDP report suggests that Canada’s economy performed well in Q4, indicating solid momentum heading into the potential trade shock.

U.S. Highlights

• The U.S. economy ended 2024 on solid footing, expanding at a 2.3% annualized pace. The consumer did the heavy lifting, with spending accelerating in the fourth quarter.
• The Fed’s preferred inflation gauge, the core PCE deflator, continued to hover somewhat above target in December, growing at 2.8% year-on-year. But trends over the past few months suggest further cooling ahead.
• Major action may come on the trade policy front as early as this weekend, with President Trump reiterating his intentions to impose tariffs on Canada and Mexico – America’s largest trading partners.

Canada – Tariffying

On Thursday President Trump reiterated his threat of a 25% tariff on Canadian imports as early as Saturday. This opens the strong possibility that Canada will retaliate with tariffs of its own, although the dollar amount of U.S. imports targeted by these tariffs isn’t yet public news. There is still some time left for lawmakers in both countries to negotiate a deal to avoid this outcome, but it seems increasingly likely that tariffs are imminent. The Canadian dollar sagged a bit on the news but is holding at around 0.69 U.S. cents as of writing. There could be even more downside if the tariffs do indeed hit.

Amid this swirling uncertainty, the Bank of Canada (BoC) cut its policy rate by 25 basis points this week, bringing it to 3.0%. This reflected the Bank’s desire to soak up excess supply in the economy. It also made sense from a risk management perspective given the potential for a significant trade shock. Because of the uncertainty on the level and extent of any imposed tariffs, the Bank’s accompanying economic forecast didn’t explicitly build them in. In this “optimistic” scenario, GDP was seen as expanding by 1.8% both in 2025 and 2026. Inflation, meanwhile, was seen as hitting 2.1% by 2025 Q4, capping off what was a solid outlook. Alas, this goldilocks outcome is now under heavy threat, and may end up being a reminder of what could have been.

Ultimately, the damage to the Canadian economy from this skirmish will be determined by how long it lasts. To get a sense of potential impacts, it’s helpful to highlight a BoC study accompanying its interest rate decision which analyzed 25% across-the-board tariffs permanently applied by the U.S. on all its trading partners, with Canada retaliating with 25% tariffs of its own. In this scenario, GDP growth was about 2 percentage points (ppts) lower than a no-tariff situation and inflation was about 0.3 ppts higher, on average, in the first two years (Chart 1). This implies that 2025 GDP growth would flip from being firmly positive, to slightly negative, using the Bank’s baseline forecast.

The Bank didn’t have to wait long for fresh news on the state of the economy. This morning’s GDP report showed a 0.2% monthly decline in November. However, GDP looks to have picked up by the same amount in December, according to Statcan’s preliminary estimate. All told, these dynamics suggest that 2024 Q4 growth was firm at around 2% (Chart 2). At least the economy had decent momentum heading into this potentially damaging trade skirmish.

How will monetary policy respond in this backdrop? According to the BoC, the answer is complicated by the fact that tariffs will negatively impact growth and lift inflation. At a minimum, tariffs would cause a one-time increase in price levels, with a potential to morph into a more sustained problem if inflation expectations are impacted. Our initial thought is that a prolonged trade battle would bolster the case for the Bank’s policy rate fall by more than what we’d imbedded in our December projection.

U.S. – Stock Market Rowdy, Economy Steady

The last week of January began on a soft note for stock markets. As it became apparent that a low-cost Chinese artificial intelligence start-up (DeepSeek) could threaten the dominance of American rivals, the valuations of several large tech firms took a hit, weighing on major indexes. Some recovery ensued later in the week, with the S&P 500 and tech-heavy NASDAQ nearly erasing the losses from last week’s close (at the time of writing). In contrast to the rowdiness of the stock market, signals out of the economy continued to point to steadiness.

The first read on fourth quarter GDP showed that the U.S. economy ended last year on a solid footing as it grew at 2.3% quarter-on-quarter annualized. The consumer did the heavy lifting, offsetting a notable drag from gross fixed private investment (Chart 1). Goods spending carried the torch once again, propelled forward by a double-digit increase in durable goods, but services also notched a mild acceleration. Meanwhile, within the softness of the broad private investment category, residential investment was a bright spot for a change, lifted by a double-digit gain in housing starts last quarter. Looking at the big picture, the fact that the economy essentially sustained 2023’s pace through 2024, despite the still elevated interest rate environment, is an impressive accomplishment.

Friday morning’s monthly PCE report provided some more detail with respect to consumption and inflation trends at the turn of the year. The handoff to the start of 2025 is solid, as real spending growth remained robust in December, growing at nearly 5% annualized. This, as strength in services helped offset some cooldown in goods spending from the double-digit gain in the month prior. Additionally, the Fed’s preferred inflation gauge – core PCE – held at 2.8% in year-on-year terms. The fact that the 3-month and 6-month annualized rate of change in core PCE inflation gravitated lower toward the target, was a welcome development (Chart 2).

With inflation still somewhat elevated (though appearing to head in the right direction) and the economy remaining on solid footing, the Fed can afford to take a cautious approach to further loosening monetary policy. The FOMC left the policy rate unchanged at this week’s meeting – a move that was widely anticipated. Fed Chair Powell acknowledged that “we don’t need to be in a hurry to adjust our policy stance”, while nodding to the uncertainties and the risks related to major policy changes out of Washington, such as on trade policy. Powell reiterated a wait-and-see approach, stating that they’d need any new policy changes to be articulated first, before assessing their impacts on the economy.

Major action on the trade front may come as early as this weekend, with President Trump reiterating his intention to impose 25% tariffs on Mexico and Canada on February 1st. There’s still a possibility that cooler heads will prevail, as President Trump’s top pick for commerce secretary suggested that tariffs could be avoided if swift action was taken on the border issues. Still, the deadline is fast approaching and any trade skirmishes with its neighbors will be problematic – the two countries are America’s largest trading partners and are deeply integrated in supply chains.