Recession or Not, the Economy Will Bear the Consequences of the Trade War

One of the most pressing questions we get is whether a recession is on the horizon. It is also one of the hardest to answer with conviction. Just a few months ago, economists and financial markets broadly agreed that the Trump administration’s trade policies—disruptive and fundamentally at odds with decades of liberalized trade—were steering the US economy towards contraction.

But Trump’s tendency to delay, exempt or walk back his most aggressive proposals has muddied the picture. The risk of a prolonged tariff shock—particularly through the inflation channel and its erosion of household purchasing power—now appears somewhat reduced. The hard data so far, including on jobs and inflation, have shown limited damage. That offers a bit of reassurance, but it remains too early to conclude that the divergence between sentiment data, which many indicators have shown collapsing, and hard data, which shows resilience, will persist.

We expect the next quarters will see US domestic demand growth slow to a halt and inflation respond gradually to the rise in the effective tariff rate, higher inflation expectations and a weaker US dollar. An enduring rise in energy prices in the wake of the flare‑up in Mideast tensions would further consolidate the trend. Recession risks are still elevated, but the US exited 2024 with strong momentum, and it might take more to push the economy over the edge.

Recession or not, it’s the longer‑term story that raises greater concern. The deeper damage stems from chronic uncertainty. When the rules keep shifting—on tariffs, immigration and taxation—it paralyzes decision making. If businesses expect another policy change just around the corner, whether positive or negative, they’re less likely to commit. Hiring and investment get deferred. In a climate of permanent change, inertia becomes the default.

Add to that the growing perception that the United States is becoming a harder place to either export to or invest in. Measures like Section 899 introduced into the US tax code by the One Big Beautiful Bill Act being pushed through Congress targets foreign investors and businesses from countries with “discriminatory” tax policies, reflecting a broader shift towards using taxation as a tool of economic leverage. While tariffs are relatively unpopular and may face legal challenges, the instinct to use policy tools to pressure trading partners remains politically attractive to Republicans in Congress.

Meanwhile, escalating deportation rhetoric risks hollowing out the US labour force at a time when unemployment is already near historic lows and the population is aging. The attacks on the US’s world‑class academic and scientific institutions are equally troubling; these are not the kinds of wounds that show up in the next quarter’s GDP, but the kind that reveal their damage across decades.

In Canada, which has found itself on the receiving end of US hostility on multiple fronts, the economic damage is more visible. Trade volatility has surged, and early Q2 data confirm that net exports are weighing heavily on GDP. Employment in trade‑sensitive sectors continues to soften, and there are early signs—albeit modest—of retaliatory tariff pass‑through in inflation data.

Despite recent tax relief measures, the broader macro picture remains fragile. Slowing population growth, mortgage renewals at higher rates and faltering real estate markets in Toronto and Vancouver all point to further domestic headwinds. We expect real GDP to remain sluggish through the summer, with a recovery more likely in the fall. Unemployment, already rising in goods‑producing sectors, is likely to spill over into services. From this perspective, recession risks appear more elevated in Canada than in the US, though it remains a close call. Rather than get lost in a semantic debate over the R word, it’s more useful to view the next few months as a slump—one shaped by both global turbulence and made‑in‑Canada pressures, but with scope for a gradual rebound.

Central banks are walking a fine line. Both the Bank of Canada and the Federal Reserve remain vigilant, not because inflation is accelerating meaningfully just yet, but because inflation expectations are, and businesses appear to have every intention to pass cost increases along. Following the pandemic, many firms discovered they could raise prices, even when they didn’t have to. This suggests a possible new pricing dynamic, one in which markups can be opportunistic, not just reactive, and central banks don’t want to be caught downplaying this risk once again.

Still, that doesn’t mean they have no more room left for rate cuts. Particularly in Canada, if domestic momentum weakens further, a widening output gap will exert additional downward pressure on inflation. Combined with tighter financial conditions—driven by a stronger loonie and elevated market yields—this implies that fiscal measures announced so far will come up short. While timely, tax relief measures are still relatively modest. Meanwhile, the fiscal pièce de résistance—namely, infrastructure projects—has yet to be detailed and will likely begin ramping up meaningfully only over the next several years.

Made‑in‑Canada Uncertainty

What sets this period apart is not just the economic conditions, but the policy environment itself. The 2025 federal election resulted in a Liberal minority government that has since pivoted to a more explicitly pro‑growth agenda. Yet in the spirit of “not letting a good crisis go to waste,” we’ve also witnessed the rushed passage of certain legislation, the postponement of the federal budget to fall 2025—creating uncertainty around fiscal direction—and a notable rhetorical shift on trade policy, from tit‑for‑tat assertiveness and shift towards Europe, to a more conciliatory tone with the US.

While these decisions may have sound strategic underpinnings, they contribute to a broader sense of unpredictability about the government’s overarching vision, particularly given how significantly it diverges from the approach of the same party under its previous leadership. The good news is that there are strong signals that Canada is now more open for business. The bad news is that if it seems too good to be true, it probably is. Sooner or later, the government’s bold ambitions will run up against familiar obstacles: labour shortages, union resistance, political friction and jurisdictional constraints. The real test will be how it manages to navigate these headwinds in a minority context.

The bottom line is that the economy is likely to limp rather than leap forward in the near term—and that’s before accounting for the litany of risks explored in this report. Policy coherence will remain elusive, the waters will stay murky and predictability, which is the cornerstone of effective decision making, will be in short supply. We still expect cooler heads to prevail and clearer skies to emerge, but for now, that outlook rests uncomfortably more on hope that political incentives will align to produce such an outcome than on any firm signal.