The Canadian economy was improving before the escalation in U.S.-Canada trade tensions. Economic activity and labor market seemed to be getting better in the second half of last year and January 2025 to raise likelihood of the Bank of Canada to pause its rate-cutting cycle.

Real GDP grew at 2.6% annualized during the fourth quarter, following a 2.2% growth in the third. Full-year GDP growth was 1.5%, not different than in 2023 but with an encouraging quarterly profile--one of increasing growth momentum (opposite of 2023).

Households led the way with the growth surprise. Business outlays also showed improvement, together with the unemployment rate stabilizing and then dropping to 6.6% in February from its 6.9% peak in November. February employment gains came in weaker (a muted 1,100 rise), but that was partly due to unseasonably severe winter during the survey reference week. Statistics Canada noted that the heavy snowstorms across the country contributed to a steep 1.3% month-over-month decline in hours worked. Home sales and industrial activity both picked up in the second half of the year. The passthrough from the lower interest rates turned out to be larger and faster than we had assumed.

Chart 1

Chart 2

Temporary fiscal stimulus, in the form of sales tax holiday and some front-loading of exports ahead of U.S. tariffs, appear to have given the first-quarter growth a boost. We expect first-quarter growth to be near 1.5% annualized after accounting for retail sales hiccup in February.

That said, just as economic activity had started to gain momentum, the U.S.'s shifting trade policy mix is altering the economic outlook for Canada. We expect the uncertainty on the trade front to weigh on consumer and business sentiments as well as on spending, with quarterly annualized growth averaging 1.2% for the rest of the three quarters of 2025. Exports, a major part of the Canadian economy, also suffer not only because of tariffs but also due to a weaker U.S. growth (now expected to decelerate to 1.6% by the end of 2025). This would bring Canada's fourth-quarter over fourth-quarter growth in 2025 to 1.3%, which is more than a 1 percentage point short of 2024's economic expansion.

The reason our macro forecast is not as bad as the consensus is because of our assumptions for tariffs. Our assumptions for tariffs on goods, excluding energy, are smaller than the 25% announced by the Trump administration (and given a reprieve until April 2 for goods covered by USMCA, which account for more than 50% of Canadian exports to the U.S.). The reason behind such assumptions is to strike a balance between the risk that tariffs are negotiated down swiftly, with the risk that the rates stay high and last longer. Additionally, we have opted to wait and see how the "reciprocal tariff" announcement by the Trump administration scheduled to come on, or after, April 2 treats the Canadian trade relation. After all, Canada's trade surplus is less than 1% of GDP, once energy is excluded, and the tariff differentials by our calculations using the 2023 data is barely positive (+0.11 percentage points) in favor of Canadian imports from the U.S. At a HS-6 digit product basis, the weighted average tariffs on Canadian imports from the U.S. is 2.03%, while U.S .imports from Canada are 1.92%.

Chart 3

Our forecast assumes the U.S. applying a 10% weighted average tariff rate on imports from Canada (including 25% tariffs on aluminum and steel), most of which will be ramped down in 2026 until it hits near 0% after Canada-United States-Mexico Agreement's (CUSMA) re-ratification. The forecast also incorporates retaliatory tariffs—only the C$30 billion in the first tranche already announced by Canada--, which will be ramped down in parallel next year. Steel and aluminum tariffs by the U.S. remain at 25%.

In our baseline, growth picks up in 2026 as tariffs are negotiated away and CUSMA is re-ratified. The Bank of Canada, which has been leading other major economies in easing interest rates, lowers the interest rate to 2% by the end of 2025 to stop deterioration in the unemployment rate and keeps the interest rate at the low end of its estimated neutral 2.25%-2.75% target through 2026. It errs on the side of keeping the rates low to help offset the headwinds from U.S. trade policy in 2025, despite the risk of rising inflation expectations. The same rate cuts will work to provide tailwind for catch-up growth in 2026. The unemployment rate peaks in the fourth quarter of this year at 7.0%, and falls to 6.5% in 2026 and 6.0% in 2027.

Chart 4

Chart 5

In a risk scenario where tariffs of 25% are implemented (instead of 10% in our baseline) and stay on through the year, the growth picture would look decisively worse. In an earlier scenario analysis exercise, we found that 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), the hit to GDP would be approximately 2.5% in the next 12 months, compared with a scenario of a no tariff. A linear mapping of that analysis into this current baseline would result in real GDP growth of 0.9% in 2025 and 1.3% in 2026.