US tariffs pose recession risk for Canada, Capital Economics warns

Investing.com -- The imposition of US tariffs threatens to push Canada towards a recession, warns a report by Capital Economics. The tariffs, which are currently at 25% on most goods from Canada, could result in a prolonged period of weak GDP growth for the country, even if they are lifted soon. This is due to the change they represent in the US-Canada trade relationship, combined with falling immigration and poor productivity growth.

President Trump's recent comments indicate that these tariffs are intended as a punitive measure against countries that, in his view, have taken advantage of the US. While there is a possibility of the tariffs being lifted due to pressure from US business leaders or negative market reactions, the default option seems to be to keep them in place.

The impact on Canada's GDP in the first year of the tariffs could be a reduction of about 3%, according to previous estimates by Capital Economics and the Bank of Canada. The tariffs on energy products are lower, at 10%, but this is unlikely to significantly alter the overall impact, as many US refineries process Canada's heavy crude. Higher tariffs in other sectors, such as steel and aluminum, will offset the lower energy tariff.

The Canadian government is expected to respond by providing fiscal transfers to affected firms and workers, which would mitigate the downturn and labor market weakness. However, with parliament adjourned until March 24th and a power vacuum following the resignation of Prime Minister Justin Trudeau, there are concerns that the fiscal response may be delayed. If the tariffs remain in place for a long period, they could cause lasting damage to Canada's economic potential.

In retaliation, the Canadian government has imposed its own 25% tariffs on CAD$155bn of imports from the US, which will increase inflation. The first tranche of these tariffs has already taken effect on $30bn of imports, with the larger tranche to follow in three weeks. These tariffs will raise import prices by $39bn, which could increase consumer prices by over 2%. This comes at a time when the loonie has fallen 7% against the US dollar in the past six months, further increasing pressure on prices.

The Bank of Canada is expected to respond to the situation by cutting interest rates by at least 25 basis points next week. A larger 50 basis point move is also a possibility. The current market reaction has been limited, with the CADUSD at $0.69, suggesting that investors are expecting a reversal of the tariffs.

Capital Economics has outlined two potential GDP scenarios. In the more positive scenario, the tariffs are lifted within three weeks, resulting in weaker GDP growth due to a freeze in large-scale investments and a rise in precautionary saving. In the downside scenario, the tariffs remain in place indefinitely, leading to a contraction in GDP over the rest of the year.

There are additional risks for Canada. The executive orders signed by President Trump state that the administration will increase tariffs in response to retaliatory tariffs, which could further harm Canadian GDP. If the increased cost of living and the negative impact on the labor market leads to an exodus of temporary residents, it could cause a drop in rent and house prices, potentially triggering a deeper recession.