Evaluating the potential impacts of US tariffs

The new US administration is considering sweeping tariffs on imports. While many important elements are unknown, these measures could be highly disruptive to the Canadian and US economies.

US President Donald Trump has said his government would impose tariffs of 25% on goods from Canada and Mexico. He has also threatened tariffs on goods imported from other countries. This could lead to countermeasures by the United States’ trading partners, including retaliatory tariffs.

Tariffs are taxes on imports that increase the price consumers and businesses pay for goods and services.1 Tariffs affect spending, trade flows, government revenue, exchange rates, employment, gross domestic product (GDP) and inflation. They could substantially disrupt supply chains in Canada, the United States and elsewhere around the world.

In general, the economic impacts for a country imposing import tariffs depend critically on how easily businesses and households can find non-tariffed substitutes. When substitutes do not exist or cannot easily be produced in higher quantities due to capacity constraints, tariffs are more disruptive to the real economy and lead to higher inflation. In contrast, the effects are more muted when close substitutes are readily available.

At a minimum, a permanent tariff will cause a one-time, permanent increase in price levels. Whether tariffs lead to ongoing inflation will mostly depend on how household and business expectations for inflation respond to tariff-related price level increases. When expectations are well anchored to the inflation target, tariff-related price increases will have less of an effect on other prices and wages. The increase to consumer price index (CPI) inflation will therefore be temporary.

The ultimate scale, breadth, timing and duration of any US tariffs remain highly uncertain. It is also unclear how affected countries, including Canada, will react.

An illustrative tariff scenario

Given the uncertainty around future global tariff policies at this time, the Bank has chosen a simple scenario to illustrate how the global and Canadian economies could be affected by a trade conflict. This is not a forecast, but rather a hypothetical scenario that makes the following important assumptions:

• The United States imposes permanent tariffs of 25% on all the goods it imports, including from Canada.
• In response, the United States’ trading partners, including Canada, impose retaliatory tariffs of 25% on their imports of goods from the United States.
• The pass-through of tariffs to prices for final goods is initially low but increases gradually over time. In the meantime, businesses’ profit margins are reduced because they absorb part of the increase in costs.
• Half of the tariff revenue raised by each country, including Canada, is transferred back to households, while the remainder is used to pay down debt.

In Canada, a trade conflict would negatively affect both exports and imports:

• US tariffs make Canada’s exports to the United States—its largest trading partner—less competitive, leading to a significant decline in the volume of exports.
• Because US tariffs are applied to goods from all its trading partners, global exports and GDP decline. Lower global demand in turn reduces commodity prices, including the price of oil—one of Canada’s major exports.
• Lower global activity further reduces demand for Canadian exports.
• Canadian imports decline because of Canada’s retaliatory tariffs on US goods. This leads Canadian households and businesses to substitute US goods for goods that are not subject to tariffs.

On the whole, Canada’s trade balance worsens. Together, lower net export volumes and weaker terms of trade lead to a depreciation of the Canadian dollar.

Canadian business investment also declines significantly due to a combination of weaker export activity and an increase in the cost of imported investment goods from the United States.

• The cost of machinery and equipment imported from the United States rises in response to Canada’s retaliatory tariffs and the depreciation of the Canadian dollar. Imports from the United States comprise about half of overall business investment in machinery and equipment in Canada.
• Lower business profits also weigh on business investment during the period when businesses partially absorb cost increases associated with Canadian tariffs.

Faced with less demand, Canadian exporters lower production and lay off workers. This, in turn, negatively affects the rest of the economy by reducing demand for goods and services that are not traded, such as housing and dining in restaurants. An increase in government transfers to households financed by tariff revenues provides a partial offset.

Over time, the decline in business investment significantly reduces potential GDP in Canada, leading to a permanent decline in GDP.

Inflation generally rises, reflecting the net impacts of two offsetting factors:

• GDP declines because of weaker net exports and weaker domestic demand, resulting in significant excess supply in the short run. Commodity prices also decline. Together, these factors weigh on CPI inflation.
• Canada’s retaliatory tariffs on all goods imported from the United States have a direct and indirect impact on consumer prices.
  • Imports from the United States of final consumer goods and intermediate inputs used to produce final goods make up about 13% of the CPI basket in Canada.
  • Prices paid by consumer-oriented businesses for other production inputs, such as equipment and machinery, also increase in response to tariffs.
  • Together with the depreciation of the Canadian dollar, these direct and indirect pass-through effects more than offset the drag from excess supply and lower commodity prices, leading to an increase in CPI inflation.

A quantitative example

Models can be very helpful for understanding the many ways tariffs could affect growth and inflation. To create the hypothetical tariff scenario, the Bank used its standard global and Canadian projection models in conjunction with a specialized trade model.3 This multi-model approach helps to better capture how tariffs on many different goods and countries affect key macroeconomic variables.

The absence of large, broad-based tariffs in the past makes it difficult to quantify with precision how their effects would flow through the economy. Therefore, in addition to the benchmark calibration, the Bank has produced a number of variations using different assumptions about how households and businesses respond to tariffs. However, the trade scenario is the same across each variation. In all cases, it is assumed that the United States increases tariffs on all imported goods to 25%, and its trading partners respond by increasing tariffs on imported goods from the United States to 25%. All results are presented relative to a no-tariff scenario.

Benchmark calibration

The benchmark calibration assumes the historical averages for:

• the response of US demand for Canadian exports to price changes.
• the amount of time it takes for cost changes to be fully passed through to the Canadian CPI (three years)

In the benchmark calibration, average annual GDP growth in the first year is about 2.5 percentage points lower than it would otherwise be (Chart 27, red bars). In the second year, it is about 1.5 percentage points lower. By the third year, GDP growth has roughly returned to normal. In other words, if annual average growth were projected to be 2% in years 1 and 2 with no new tariffs, then the growth forecast would be about -0.5% in year 1 and 0.5% in year 2 with the new tariffs.

While the effect of tariffs on the rate of growth is temporary, the level of GDP is permanently lower, reflecting a decline in the long-run level of Canadian productivity due to the distortionary effects of tariffs.

Because cost increases associated with Canada’s retaliatory tariffs are assumed to be gradually passed on to consumer prices over three years, CPI inflation is subject to sustained upward pressure over this period (Chart 28, red bars). Considerable excess supply and declining commodity prices largely offset the direct impact of tariffs in the first year, but inflation rises as excess supply is gradually absorbed in subsequent years.

Sensitivity analysis around the benchmark calibration

The assumption of wide-ranging 25% US tariffs and full retaliation represents a significant relative price shock for an economy like Canada with strong trade links to the United States. Tariffs affect supply and demand in complex ways, and some prices are more affected than others. Wages and other business costs also adjust. In turn, businesses are likely to change what they produce and how they produce it, while consumers substitute away from some goods and services in favour of others. Gauging the net impact on economic slack and inflation is difficult. In particular, the relative strength of the various forces acting on inflation depends critically on:

• how much Canadian export volumes decline and the related spillover effects to business investment
• how sensitive Canadian inflation is to tariffs on US exports to Canada, particularly for consumer goods

To illustrate these sensitivities, the Bank has created a number of variations on the benchmark calibration (Table 4). How these variations impact GDP growth and inflation is shown in Chart 27 and Chart 28.

Larger decline in US demand for Canadian exports

Estimates of the sensitivity of Canadian exports to price changes are based on historical data and are found to be quite low. However, in the case of such a large shock, it is possible that exports could fall by considerably more than predicted by the Bank’s projection models. Increasing the sensitivity for both commodity and non-commodity exports to US tariffs results in a more significant decline in exports and business investment and, as a result, weaker GDP growth (Chart 27, yellow bars). It also leads to a more significant depreciation of the Canadian dollar because Canada’s trade balance worsens by more than with the benchmark calibration.

The impact of weaker demand and a weaker dollar have partially offsetting effects on consumer prices. As a result, CPI inflation is only modestly lower than in the benchmark calibration (Chart 28, yellow bars).

Lower tariff pass-through to consumer prices

In the benchmark calibration, it is assumed that the increased costs associated with tariffs are fully passed on to consumer prices after three years, meaning that businesses no longer absorb any of the cost increase after that point. If instead only 50% of the cost increase associated with tariffs is passed on to consumers after three years, inflation declines in the first year. This decline occurs because the drag on inflation from excess supply and falling commodity prices now outweigh the effect of tariff-related price increases (Chart 28, green bars). In subsequent years, inflationary pressures are also lower than with the benchmark calibration.

GDP growth does not decline by as much as it does in the benchmark calibration (Chart 27, green bars) because prices rise by less and, as a result, consumer purchasing power declines by less.

Faster tariff pass-through to consumer prices

Since the adoption of inflation targeting in Canada, changes to input costs have not usually led to significant increases in inflation. This suggests that a large portion of input cost changes are initially absorbed in businesses’ profit margins. However, it became clear in the pandemic that large cost changes can be passed through to prices much more quickly. Because a 25% tariff would lead to a significant increase in costs for businesses, they may adjust their prices more quickly relative to the historical average. In this variation, the time it takes for businesses to fully pass through the costs of Canadian import tariffs is reduced from three years to one and a half years (Chart 28, blue bars).

With faster pass-through, inflation initially increases by more, but also comes back down more quickly relative to the benchmark calibration. The implications for GDP growth, relative to the benchmark calibration, are small (Chart 27, blue bars).

Endnotes