Trouble in Tariffs

Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.

Avery Shenfeld: Welcome to another edition of Eyes on the Economy. I’m Avery Shenfeld, Chief Economist of CIBC, and I’m joined by Ali Jaffery, a Senior Economist on our team, to talk about what’s very top of mind for all Canadians these days, which is the threat of tariffs being posed by our key trading partner to the South and what that might mean for Canada. We find ourselves, of course, in a bit of a situation where we’re in a limbo waiting to find out whether we’re going to be hit by 25% tariffs on everything we sell the US and 10% on energy, or whether it’s just tariffs on steel and aluminum at 25% for both, or whether Canada will be wrapped up in a broader tariff on all US imports. But either way, that threat is now causing some uncertainties in our forecast and will inevitably dent economic activity or the growth rate in economic activity even on just the fear of that. So what does this new reality look like? Well, at this point, we’ve knocked down our Canadian GDP forecast for this year to about one and a half percent. That’s a few ticks off just on the threat of tariffs, the potential tariffs on steel and aluminum, and the impact that that’s having on business confidence, at least till we find out where we actually stand. But in a recent report, Ali Jaffrey and I took a look at Canada’s tariff troubles and looked at some of the tougher outlooks that might come about if we’re hit by broader and deeper tariffs across the board. If tariffs were to hit, we know the general direction of what that would do to the economy. We would have an initial shock to economic activity and in some cases, outright recession. We’d bring the economy back to some extent with monetary and fiscal stimulus and perhaps a weaker exchange rate helping our cushion the blow to our exports. But GDP would be on a permanently slower path in terms of the level of economic activity because of the loss of the gains of specialization and trade. On inflation, there’d be a similar roller coaster where initially inflation would move higher. Not only because Canada would put retaliatory tariffs on US goods, but because there’d be also the impact on inflation of a weaker Canadian dollar and what that means to our purchasing power abroad, as well as the fact that US manufacturing costs would rise due to their own tariffs on intermediate goods. And some of that would end up being passed on in their export prices to Canada. But the longer term impact or the medium term impact of what could be a big hit to growth or an outright recession, would be push inflation lower again and require some offsetting stimulus to the Canadian economy. So with that, we turn to the hard part, which is what can we say about the magnitudes of those hits to GDP and the inflation moves through the various phases of that reaction function at different levels of tariffs. We took a look at that and to go over the details of what we found, I’m going to turn it over to my colleague, Ali Jaffery. Ali?

Ali Jaffery: Yeah, thanks, Avery. And, you know, before I give these numbers, I just want to give a very important disclaimer that, you know, take this with a grain of salt. There’s no possible way one can properly model and get all the channels and all the kind of knockoff effects of tariffs. And so what we’ve used is a range of assumptions, which we’ve noted down, or at least the key ones in the note. And we’ve drawn things from the literature and using our own empirical work. and come up with rough estimates of how over the medium and long term tariffs would impact the economy without taking into account the of fiscal and monetary policy. And so what we came up with is, and we looked at three main scenarios. One is a tariff on Canada excluding the commodity sector of 10%, then 20% tariff excluding commodities, and then the 25% on everything except for a 10% tariff on energy. We came up with an impact of about 2% to 5% across those scenarios. And that includes retaliation by Canada on about 25% of its imports. So a fairly material hit to GDP. just to put those numbers in context, if the level of GDP drops by 2%, you know, that’s in historical standards, a recession, a moderate recession, and you know, 5% impact, which is that 25%, 10% on oil. That’s in the order of magnitude of the global financial crisis. So fairly, fairly sizable hit to the economy that would require monetary and fiscal policy support across all those range of scenarios. Now, inflation, however, is a different impact, a bit of a multi-stage ride on inflation. Initially, yes, inflation would rise. And we think that in the more severe scenarios, the 20% with carve-outs or the 25% without carve-outs, inflation could rise by a percentage point and a half. And when we apply that to our base case, that would bring it to the top end of the range of the Bank of Canada’s control band, which is around 3%, slightly above that. And that would happen, you know, three quarters, four quarters in, but then in the second year, inflation would fall materially and stay, either go below the Bank of Canada’s control age or stay below 2% for the entire year and a year over year basis. So you’d have a pickup in inflation initially, but then a decline as those price level impacts fade and slack in the economy isn’t dissipated. So very weak GDP and then a temporary hit on inflation but then significant disinflationary pressures thereafter.

Avery Shenfeld: Thanks very much, Ali. I think that we also did some details at the provincial level for those interested. Ontario and Quebec being the heartland of Canada’s manufacturing sector naturally end up bearing the bigger part of this shock. So a larger share of the hit to GDP relative to their share of GDP. So they’re the most affected as you might expect. And within manufacturing, there’s quite a big range. So sectors like primary metal, which oddly enough happens to be the sector that Trump seems to be targeting this week for tariffs from Canada, is going to be one of the most sensitive sectors just because exports to the US are a big part of its activity. And in the case of steel, the US has some capacity to substitute for Canadian manufactured products that are exported to that market. At the other end, you have sectors like beverages where, you know, Canada doesn’t bottle Coca-Cola for the US market. It’s pretty much a domestic industry. So not particularly affected by tariffs. So it’s quite a range of outcomes. I think the most important part of the findings that Ali went over is in fact the findings on inflation, because you’ve heard some cross currents on what the Bank of Canada’s reaction would be or ought to be in the event that we’re in a material bilateral trade war with the US or two-way trade war on tariffs. The key here is that the inflation impacts are a one-time impact that are temporary. The disinflation impacts of what could be either a complete stall in growth or an out-right recession would over time start to swamp that. And the message for the Bank of Canada, I think, will be pretty clear. They’ll need to ease more aggressively in the event of a trade war than they would otherwise. And in fact, even in the outcome that we’re hoping for, which is that these trade threats go away in a few months, the hit to business confidence that they will engender in the meantime is just another chip on the side of the Bank of Canada continuing to ease rates towards what was our target at 2.25% overnight rate, another 75 basis points. But in fact, a chance if we do get into a trade war of even deeper cuts. So overall, this is certainly not a happy time for the Canadian economy. There’s still a lot of unknowns here. We’re hoping Canada doesn’t feel like the Kansas City Chiefs felt on Sunday, but in the near time, we’re obviously concerned about a material dent to growth, even at the outside edge, at risk of a serious recession. And monetary and fiscal policy would have to come to the rescue, stimulate domestic demand enough to, over time, start to offset some of that shock. But it’s not something we could expect to cure right away. So with that, we’re going to be watching on behalf of our clients, all of these developments on almost a daily basis. It seems like we’re getting news there. We invite you to read the study that Ali and I were talking about. It’s on our website. It’s called Canada’s Tariff Troubles: Recession Trumps Inflation as the Worry. And with that, I’d like to thank you for joining us again for another issue of our podcast. In the meantime, we’ll be keeping our eyes on the economy and calling it as we see it.

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