Where are the US and Canadian economies headed?

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.

Katherine Judge : Welcome to CIBC’s Eyes on the Economy podcast. I’m Katherine Judge, a senior economist at CIBC. And today I’ll be discussing the US and Canadian economic outlook with Ali Jafri, a senior economist. So we’ll start with the US economy for some context. So we got the employment data for May on Friday, Ali. It did show a cooling due to trade uncertainty. Where are we really seeing the impacts of tariffs on the economy?

Ali Jaffery : So, as you mentioned, we put out our forecast outlook. And for the US section, we called it, it’s the end of the world as we know it, and the US economy feels fine. And I think that’s a good summary of where we are on the US outlook that, yes, we’ve had this massive change in tariff policy and a range of other policies are shifting around a lot. And yeah, it’s probably going to dent the US economy. We expect growth to slow by about a percentage point.

in 2025, the labor market to cool gradually but nothing really, you know, a really sharp rise in the unemployment rate. And overall the economy, you know, will kind of be okay, we’ll get through this, but not without being dented in some areas. So, you know, our research shows that, you know, what as many people expect and understand that the US economy, although it’s facing a very material trade shock,

It has the benefit of one, entering the trade war on very strong footing, know, growing around 3 % annualized over the past couple of years, labor market imbalance around its long run unemployment rate level, dynamism slowing, but still not very unhealthy. So, it has the luxury of entering trade war in a strong position. And also it has the benefit of not being a very trade intensive economy either that, imports are not a massive share of the economy and trade overall exports and imports together about quarter of GDP and that’s much lower than other advanced economies. And even we’ve looked at the linkages between manufacturing and services and those have also diminished particularly since the financial crisis and overall import intensity, the share of imports of overall intermediates has declined since the previous trade war. So, we see an economy that isn’t really exposed to trade. And the main channel through which the trade war is going to affect the US economy is through the erosion of purchasing power of households. So, the inflation shock, how big is it going to be, is really the big question for monetary policy and also the evolution of the economy. And looking at the current tariff regime, and obviously the big caveat around our analysis is we assume that

Ali Jaffery : The tariffs that are in place right now, which I know are subject to legal challenge and we’re going to see how that goes. But we’re assuming that you have effective tariff rates of 13 to 15 percent, differentiated by country with China having larger effective tariff rates and the neighborhood of 25 to 30 percent effective tariff rate. In that world, assuming that’s kind of where we end up, it’s a price shock of about 1%on core PCE. And when you add in some of the slack, we think that that impact on core inflation in the US is going to be bringing core inflation to around 3 % year over year by the end of the year. But the price shock will be passed on pretty quickly in the summer and the fall. And then the sequential inflation rates will start to moderate by the end of the year and early next year. And so, for GDP, the tariffs will probably knock off about half a percent of GDP. And the immigration also, immigration changes will probably weaken GDP by 0.2%. So, overall the drag from the administration policies will be around 0.7 is what we estimate by the end of 2026. And the Fed and we’ll see what happens with fiscal policy. We don’t really build that into our forecast yet because we know that the one big beautiful bill or whatever it’s being called these days is probably going to see some major changes in the Senate. So, we haven’t built that in yet, but we think the impact over our forecast horizon at least will be pretty modest and you’ll have growth kind of in the low 2% in 2026.

Katherine Judge : Well, that was a really thorough overview and actually answered a lot of my questions. So, essentially with the tariff pass through, , where do you see the effective tariff rates settling at and under what timeline? And is there a chance the US economy could slip into recession if we don’t get enough progress on trade in the coming months?

Ali Jaffery : So, that’s a really tricky question, right? Because it depends on the legal challenges that are ongoing right now, whether the administration can continue to rely on that AIPAA provision where they can, the president can effectively impose tariffs unilaterally on national security grounds at his or her own discretion. So, we’re kind of assuming that that will…

implicitly withstand or if they have to resort to some of the other legal mechanisms, know, Section 232 and on and some of the other means that they will cobble together sectoral tariffs that are similar to what we have. But I think the answer is that look at a 10 to 15 percent effective tariff rate if we land in that range, the US economy can probably withstand that. It will slow. It’ll be a permanent shock to GDP and potential output. But it wouldn’t push the economy into recession, assuming that the consumer and firms are not overly spooked by that. And we actually looked into a range of the different measures of sentiment and the relationship with activity. And we find that, yeah, sentiment has started to come down, especially for the consumer a lot. But the relationship between consumer sentiment and consumer spending is structurally weakened a lot and it doesn’t really tell you a lot about what consumers are actually doing and in fact it’s probably picking up more partisan differences that are happening than anything to do with actual spending. So, we’re not in a recession camp if tariffs stay where they are but if they’re ratcheted up a lot, if trade policy continues to whipsaw a lot, which it very well could, it’s hard to have confidence on that, if those things tip the other way then I think the risk of a recession would rise more, but right now we’re definitely not in that camp.

Katherine Judge : Okay, and maybe you can talk a little more about the Fed and how they’re tariffs versus the slowdown in the labor market. If it is just a one-time lift to inflation and the labor market’s slowing, , at what point do they start to feel comfortable cutting interest rates?

Ali Jaffery : So, the Fed is going to want to see through the tariff shock to see how large it is. They have the luxury to do that, as I mentioned. The economy doesn’t look like it’s falling off a cliff or will, quickly at least. You know, will cool. The labor market, we think, will gradually cool, peaking to around four and a half percent unemployment rate at the end of this year, early next year. And GDP growth will slow over the course of this year relative to where it was last year.

So, I think the Fed is going to start to ease at the end of this year is what we’ve penciled in. We have one cut in 2025 in December and then three cuts in 2026. And we think they’ll start to cut once you see that tariff shock mostly pass through and sequential inflation, you know, the month over month, the Q over Q inflation rates, look more normal or normalize. So, then they will feel more comfortable to respond to the weakness in the economy, weakness in activity. And that’s premised on what the Chair has told us, that Powell said, that they’re going to look at how far the different mandates are relative to their target. So, initially we expect inflation to be further away from a target than the labor market. And so they’ll hold for most of this year. And in 2026, it’ll be a story of supporting the economy.

Let me turn the tables here though, Katherine. Let’s talk about Canada. We’ve put together our Canada outlook. So, walk our listeners through some of the key themes and key ideas in that piece.

Katherine Judge : The first quarter was boosted by tariff front running efforts. So, there was a surge in exports to the US as businesses anticipated tariffs. And now we’re heading into the second, well, we’re in the second quarter, but the data we’re receiving is lagged. And it’s suggesting that GDP won’t expand at all in the second quarter. So, we really are feeling the impacts of the trade war, obviously Canada is a very small open economy and the US is our biggest customer these tariffs are a huge blow to the economy. And we’ve seen the unemployment rate rise about a full percentage point. So, above a healthy level. So, at 7%, it’s at a level that suggests a year from now, inflation is likely to be under target if the Bank of Canada doesn’t start to cut. So, right now we are seeing some pass through of tariffs and previous Canadian dollar depreciation and the inflation data. So, specifically in food prices, which boosts the Bank of Canada’s trim and median measures. they’re a little bit concerned about that, but in our view, the overriding factor here really should be the unemployment rate being high, GDP growth tracking extremely weak and therefore economic slack increasing. So, we do think that by the July meeting, the Bank of Canada will have enough evidence to cut interest rates by 25 basis points and then likely follow that up with a final 25 basis point cut in September as well. Obviously, a lot of this rests on what happens with trade negotiations and progress on that front.

So, we are assuming that some sector tariffs remain like steel, aluminum and lumber. We don’t expect auto tariffs will remain. There’s been a lot of pushback against those from businesses in the U.S. and those are costs that will simply just be passed through to consumers. So, we don’t think those will remain, but we are obviously in a rough patch for the economy.

Katherine Judge : The Bank of Canada cutting interest rates is against the backdrop of fiscal policy that doesn’t have a lot of stimulus built in this year. A lot of what was in the spending plan for the Liberals was infrastructure, which takes years to ramp up and actually get up and on the ground. So, the multiplier isn’t as big through that type of fiscal spending. Of course, there’s been announcements that Mark Carney expects to get defence spending up to the 2 % of GDP targets set by NATO during this fiscal year. But, we don’t have details on that at this point.

We obviously do need to increase defence spending. We’ve been very weak at about 1.5 % of GDP on that measure and the target is expected to increase to above 3 % as well at the NATO summit later this month. So, that’s an area where we don’t really have an industrial base in terms of defence, but perhaps R&D tied to military spending could be a productivity enhancing effect of this. So, a lot of inventions came from R &D tied to the military, like the microwave, GPS, the internet. So, hopefully it will help to stimulate some R&D activity that has broader applications within the economy. so I mean, ultimately, this is a rough patch, but assuming trade negotiations continue, I think by the end of the year, we’ll have signs of an acceleration in GDP growth.

Ali Jaffery : That is also very comprehensive, Katherine. Thank you for that. But just one final word here on that recession or no recession for Canada this year.

Katherine Judge : At this point, I would say no recession. obviously the odds are elevated this year relative to a normal year when you would typically have about a 10 % chance of a recession in any given year. It’s much higher than that and depends a lot on what Trump chooses to tweet out on any given day, which can cause chaos in markets.

Ali Jaffery : But looks like it’s just avoiding one with about flat growth in the middle of the year.

Katherine Judge : Yeah, yeah, definitely avoiding one. I’m just saying the odds are elevated.

There’s lots of factors at play here. obviously population growth is slowing a lot. So, we don’t have that source of growth, which means we do need a rebound in productivity. in terms of cyclically speaking, when we do get the rebound and growth, that always comes with an increase in productivity usually. So, we’ll see that, but just over the longer term, we’ve underperformed structurally in terms of business investment and therefore, attracting well productivity enhancing investment. And there’s a number of reasons versus the U.S. And if you look at the industry mix, tends to be in construction. Canadian businesses tend to be smaller than U.S. businesses and therefore, there’s fewer returns to scale for businesses investing in capital. So, there’s just a number of areas where we actually could have more targeted and innovative fiscal policy. I already mentioned R and D tied to military spending, but, yeah, I think there’s opportunities to really focus in on productivity over the coming years.

Katherine Judge: So, that was a pretty thorough summary of both the Canadian and US economic outlook. Thank you for joining us today. And remember, you can check out our research and forecasts on the CIBC economics website. And until next time, we’ll be keeping our eyes on the economy and calling it as we see it. Thank you.

Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.

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