The new U.S. administration has made an aggressive start in the area of tariff policy. On Feb. 1, less than two weeks after his inauguration, President Donald Trump invoked the International Emergency Economic Powers Act (IEEPA) to announce sweeping new tariffs. In taking these measures, the White House cited the extraordinary threat posed by illegal immigration and drugs, including fentanyl. The measures included:

• A 25% tariff on all goods imported from Canada, with the exception of energy imports, which would be tariffed at 10%,
• A 25% tariff on all goods imported from Mexico, and
• An additional 10% tariff on all goods imported from China (already included in our baseline).

Tariffs on China began Feb. 4, and the Chinese government responded with selected counter-tariffs on U.S. imports. The start date for Mexico and Canada was extended by one month from Feb. 4 after Mexican President Claudia Sheinbaum and Canadian Prime Minister Justin Trudeau reached agreements with President Trump on measures to improve border security. The situation remains in a state of flux.

Our initial views on the macro and financial impact of the tariffs are limited to key economies and key variables for 2025 and 2026. We looked specifically at the effects on the U.S., Canada, Mexico, and China.

Tariffs have not yet been formally announced on the eurozone, but this risk still looms over Europe, so we consider those effects as well. Our scenario looks at 2025 and 2026 in terms of deviations from our November baseline.

Our Key Assumptions

In our scenario, we have assumed the following:

• The U.S. imposes a 25% tariff on all imported goods from Canada and Mexico starting in March 2025 through the end of the year. Canada retaliates with a 25% tariff on all U.S. imports. Mexico imposes a 25% tariff on all nonmanufacturing U.S. imports.
• The tariffs decline to 10% at the beginning of 2026, when the renegotiation of the United States-Mexico-Canada Agreement (USMCA) is likely to begin.
• USMCA is ratified in the middle of 2026, at which point tariffs between the U.S., Canada, and Mexico would return to the near-zero regime established under the trade agreement.
• Tariffs to China remain in place through 2025-2026.
• Uncertainty around tariffs does not fully disappear even if an agreement is reached in USMCA. Therefore, the estimated effects of the tariffs are not automatically unwound.

On prices, we assume the tariffs are almost fully passed through to home country consumers. This is in line with empirical evidence. While the tariff is paid by the importing firm to the home country treasury, the burden of the tariff can be different. Specifically, the burden of tariffs can fall on foreign country exporters or home country importers through lowering margins in an attempt to preserve market share. While these outcomes are possible, they do not play a large role, in our view.

Even if home country consumers bear the ultimate cost of tariffs, there can be offsets. The government could rebate the full amount of the tariff revenue back to households. However, this is unlikely to be perfectly calibrated to the tariff incidence, so there will be distributional effects. In addition, the rebates may come later than the tariff-related higher household outlays.

Finally, these results should be interpreted as preliminary. This scenario was not run through our global general equilibrium macro model. Rather, they were generated using the expertise of our regional chief economists. They should therefore be interpreted as first order approximations that do not necessarily capture all interactions between macroeconomic variables.

Our Results

In our view, the U.S.-instigated tariffs and trading partner counter-tariffs will lead to across-the-board lower GDP growth, higher unemployment rates, and higher inflation. Policy rate outcomes are mixed. Our scenario will also lead to a stronger U.S. dollar. But these effects will be highly uneven across economies.

Starting with North America, the impact on the U.S. economy (in own country percentage terms) is much lower than for Canada and Mexico. The level of GDP is around 0.6% lower in the U.S. by early 2026 and 2%-3% in Canada and Mexico compared with our previous forecast. The unemployment rate rises by less in the U.S., as does inflation. These results are not surprising given the asymmetry in both overall size and in trade dependencies as a percentage of GDP. The U.S. also enters 2025 in a stronger cyclical position than its neighbors with solid, resilient demand momentum.

The effects on China compared with our previous forecast are minimal since the 10% tariffs just announced were already assumed in our baseline. However, the U.S. tariffs are the key reason why we expect GDP growth to slow to around 4% in 2025 and 2026. We also think they will amplify downward pressure on prices and imply a weaker currency. Amid unwelcome foreign-exchange market depreciation pressures, we expect the People's Bank of China to cut its policy rate by 20 basis points less in 2025 than we assumed previously.

Additionally, this scenario does not lead to significant changes to our overall Asia-Pacific outlook. We expect a marginal hit to growth in Asia excluding China (not shown) stemming from lower exports to the three North American countries as growth there slows due to the tariffs. Because of the weaker global growth and higher competition on regional markets for manufacturing products due to the U.S. tariffs, inflation in Asia is somewhat lower. With the U.S. Federal Reserve likely to keep its policy rates on hold for much longer, Asian central banks will to varying degrees have less leeway to reduce their policy rates. Wider interest rate differentials with the U.S. are likely to lead to slightly weaker Asian exchange rates. However, we don't think the Bank of Japan's plans to gradually raise its policy rate will be materially affected.

A What-If For Europe

We also looked at a what-if scenario for the eurozone. This is because we see U.S. tariffs on the eurozone as having a material probability of being implemented this year. Our eurozone scenario assumes a 10% U.S. tariff rate on all goods starting in the second half of 2025 without immediate retaliation. We believe the EU will seek to negotiate first, particularly in the fields of defense and energy.

Lower eurozone GDP and higher inflation mostly reflect the price-elasticity of trade and the exchange rate.

The eurozone economy would suffer in roughly equal amount in terms of GDP losses from lower trade with the U.S. and from imported inflation due to a weaker exchange rate. Admittedly, the depreciation of the euro is positive for the price competitiveness of European exports that could mitigate the impact of higher tariffs. However, we believe that this upside factor is remote and more for 2027 than 2025-2026.

In this environment, we see the ECB cutting rates more than in our baseline scenario (by 25 basis points). This reflects the downside risks to growth that would persist because of weaker confidence and financial market volatility. However, we believe that the ECB's options will be limited by the higher policy rate differential with the Fed, which could exacerbate inflation risks in the eurozone through the exchange rate channel.

North American Narratives

U.S.   The overall drag on real GDP (versus our baseline forecast) is more difficult to pin down without making very strong assumptions. Our sense is that it is likely about 0.6% lower over 12 months, reflecting purchasing power loss to U.S. households, an elevated level of investment uncertainty, and a hit to American exporters.

The new tariffs are likely to temporarily boost U.S. consumer price index (CPI) inflation by 50-70 basis points, as a first approximation. Currency adjustment, product substitution, or cost absorption along the supply chain from the exporter to final consumer offers some price relief but is probably going to be limited. CPI inflation will likely approach 3% by the fourth quarter of 2025, compared with our 2.3% forecast previously.

In such an environment, we suspect the Fed would likely err on the side of keeping inflation expectations anchored. The pause on the Fed's rate easing cycle would come earlier than we currently anticipate. We suspect there would be no rate cuts this year, and it would likely not be before mid-2026 that the downward journey to a neutral fed funds rate resumes.

Canada.   Our assumption is the effects of the tariff would lead to stagflation for the Canadian economy. Combining the hit to exports, purchasing power of Canadian households, and erosion of investment outlays (which are closely correlated with exports and most capital goods are imported), we expect GDP to decline by 2.5% in the next 12 months compared with our baseline. The reinstation of USMCA partially unwinds the negative gap in the second half of 2026.

At the same time, consumer prices could rise about 50 basis points above our previous baseline. Vehicle costs are particularly susceptible. In such a weak macro environment, the Bank of Canada is likely to cut more to support the economy looking through the inflationary impulse as a one-off temporary outcome. We see the Canadian dollar weakening by another 10% against the U.S. dollar, with further downside risk as the central bank cuts rates to accommodate weakening economy. Taking into account the imported goods content in the CPI (which is about 30%) and weaker demand by consumers, overall consumer prices are likely going to rise 2.7% by the fourth quarter of 2025 compared with 2% in our November baseline.

Mexico.   Our view is that Mexican officials are likely to be pragmatic in their negotiations with U.S. officials. Their objective would be to avoid tariffs or, if tariffs materialize, to lessen their duration. However, if tariffs were to take effect and stay in place for some time (months or quarters, not weeks) the impact on the Mexican economy would be significant.

In the scenario outlined above, Mexico's GDP would be 1.7% below our baseline in 2025. Despite a recovery in the second half of next year as tariffs are removed, the GDP level would still be about 3.0% below our baseline in 2026. The depreciation of the Mexican peso, which we assume would be on average 10% weaker than our baseline, would partially absorb the higher costs associated with the tariff increase and would also drive a significant decline in imports.

The largest drag on GDP would come through consumption and investment. These would decline significantly due to the uncertainty that would likely prevail regarding the future of trade relations between the U.S. and Mexico. Inflation would be higher in 2025 due to the high content of imported goods on consumption and the sizeable pass-through of a weaker exchange rate on prices. This would, in our view, prompt the central bank to pause its current rate-cutting cycle through the rest of 2025.

What's Next?

We expect uncertainty around U.S. tariff policy to be ongoing. This applies even if agreements are reached with Canada, Mexico, and China. And it does not rule out tariffs being applied to other jurisdictions, such as the eurozone or even single member countries of the EU, and the many Asian countries with significant bilateral trade surpluses with the U.S.

This ongoing uncertainty reflects our view regarding the current U.S. administration's operating model. Our observation is that the administration seeks to strike deals and therefore treats a wide swathe of cross-border economic relations as more or less continuously negotiable. Any previous deals or agreements can potentially be reopened at any time.

It also lacks clearly defined objectives for implementing tariffs, with targets including rectifying trade imbalances, lower illegal immigration, reducing the flow of illegal drugs, and higher defense spending. The resulting uncertainty has the macro effect of complicating longer-term decision making for both firms and households. As such, it puts downward pressure on investment, demand more generally, and--ultimately--growth.

We plan to issue a full set of forecasts as well as an updated narrative and risks in our upcoming Credit Conditions Committee, which is scheduled to conclude in late March.