Risks

Given the unprecedented shift in the direction of US trade policy, there is considerable uncertainty about how tariffs could impact the economy. The degree to which prices will rise and economic activity will weaken is unclear.

Historical tariff episodes can be helpful for gauging the impact of new tariffs when they are of a similar size and scope. The Bank of Canada’s economic models use historical data from the start of the inflation-targeting period in 1991 to the present. These data include:

• tariffs that the United States imposed on Canadian steel and aluminum in 2018
• various tariffs on softwood lumber
• tariffs between the United States and China in 2018–19

The size and scope of tariffs considered in Scenario 1 are similar to recent historical experience. However, the unprecedented size and scope of the tariffs in Scenario 2 are not. In scenarios with high and long-lasting tariffs, the economic impacts are particularly uncertain.

There are two main upside and two main downside risks to inflation.

Main upside risks

Tariffs and supply chain disruptions could have a greater impact

In Scenario 2, the tariffs on Canada are assumed to cover a much wider range of goods than experienced in recent history. Because the tariff burden is so broad, businesses may pass on a greater share of the cost of tariffs to consumers than is assumed in Scenario 2. This pass-through may also happen at a faster pace. There is also a risk that businesses not directly impacted by tariffs may try to take advantage of the reduced competition and raise their prices.

The imposition of tariffs and subsequent countermeasures could also damage global supply chains more than is assumed in Scenario 2, resulting in higher production costs and import prices.

Tariffs could raise longer-term inflation expectations

Canadian tariffs will increase the prices of goods imported from the United States. Scenario 2 assumes that tariffs lead to a one-time increase to the prices paid by consumers. Once prices have adjusted to the new level, the rate of inflation will return to its previous trend. This assumption depends partly on longer-term inflation expectations of both households and businesses remaining well anchored to the 2% target.

However, consumers and businesses affected by tariff-related price increases may begin to expect that prices will continue to rise at an elevated pace after the one-time increase. This could lead to an upward drift in longer-term inflation expectations. These expectations of higher future inflation could become self-fulfilling if they feed through to wage demands and if businesses change how they set prices. This risk could be significant, especially considering the recent experience of high inflation.