For a spell this past summer, the clouds hanging over Canada’s economy were beginning to part. A hiring rebound had recouped all of the 112,300 jobs that were lost in the first four months of the year, leaving employment up a sturdy 1% from year-ago levels. In turn, the jobless rate fell steadily from a high of 7.1% in the fall of 2025 to 6.4% in July 2026. And, after famously contracting for two straight quarters, real GDP appears to have rebounded by nearly 4% annualized in the second quarter, amid a pickup in retail sales, manufacturing shipments, and home sales. The rebound has silenced recession talk and supports our forecast for a return to above-potential growth of 2.0% in 2027.

However, the outlook darkened markedly after trade talks between Canada and the U.S. broke down in late August, and relations deteriorated. The U.S. administration applied 50% duties on about 5% of Canada’s goods exports to the U.S. (representing 0.8% of Canadian GDP) under the never-used-before Section 338 of the Tariff Act of 1930 (yes, Smoot-Hawley). The tariffs on a slice of goods that were previously exempt under the USMCA marks a significant escalation in trade tensions, one that risks undermining business confidence and investment even further. While the average tariff rate on Canadian exports to the U.S. would rise only moderately, from 5.0% to around 7.5%, the industry-specific effects could be severe and spread far beyond the already-damaged steel, aluminum, lumber, and auto industries. At elevated risk are electronics, plastics, chemicals, wood products, alcohol, and clothing. Regionally, British Columbia, Quebec and Ontario look to bear the most pain, with the latter two provinces already taking the brunt of the heavy metal and auto duties.

Overall, we estimate that the Section 338 tariffs could reduce annual real GDP growth by roughly one-half percentage point and raise the unemployment rate by two tenths. From the moment the new tariffs were announced, the widespread view was that the threat was more a negotiating tactic in current USMCA discussions than a fundamental shift in trade policy. However, with the tariffs now in place, Canada retaliating dollar-for-dollar, and the U.S. Administration now threatening 50% tariffs on autos, the risks are mounting. Viewed from a wider lens, the main point here is that whatever happens with these particular tariffs, Canadian businesses are likely going to need to adapt to persistent trade uncertainty under this Administration.

For the Bank of Canada, just when it seemed that the economy was beginning to adapt to the trade war, any budding momentum risks being zapped by new tariffs and ongoing trade policy uncertainty. This threat, coupled with some slack in the economy and resulting benign inflation—most core inflation measures are now running at, or below, the Bank’s 2% target—should keep the central bank firmly planted on the sidelines. We continue to expect no interest rate moves in either direction through next year, even as the market anticipates rate hikes over the next year. In fact, a further escalation of the trade war could even push the Bank to eventually lower rates to support the economy.

The flip side is that overall inflation remains sticky at close to 3% due to the run-up in energy prices over the past year. Renewed U.S. and Iran military attacks have shut the Strait of Hormuz once again, while Houthi attacks in the Red Sea threaten to disrupt another critical shipping route for global energy and supplies. Consequently, U.S. oil prices have rebounded and are expected to average at least $80 in 2026 (and we expect $75 next year), while gasoline prices have been even firmer.

Although North American consumers have managed to maintain spending despite higher fuel costs, the latest surge could prove damaging in another way: by keeping inflation elevated and potentially pushing central banks to tighten policy. Already, the sustained strength in energy prices has been a big factor behind driving long-term bond yields higher. For example, the 30-year Government of Canada bond yield recently pushed above 4%, hitting its highest mark since 2010. Similarly, the benchmark 10-year U.S. Treasury yield has risen above 4.7%, close to its highest level since 2007, lifting long-term mortgage rates and dashing hopes of a U.S. housing recovery.

Prior to the renewed flare-up in tensions in the Middle East, stronger economic data and a benign July CPI report had also brightened the U.S. outlook, spurring a modest upgrade to our forecast while reducing the risk of Fed tightening. Despite softer-than-expected real GDP growth of 1.5% annualized in Q2, which was largely due to increased imports and declining business inventories and federal spending, underlying economic activity remained solid. Real final sales to private domestic purchasers rose 3.9%, the most in over three years. Consumer spending growth accelerated to 3.2%, while nonresidential business investment grew 8.4%, led by a 15% surge in equipment spending. Real investment in computer hardware, software and data centre construction—a broad measure of the impact of the AI build-out—simmered down only slightly to 18% y/y in Q2 from 25% in Q1, but still added an estimated 0.6 ppts to GDP growth (of a total 2.1%) in the past year. However, surging imports of computer hardware cut the net contribution roughly in half. For all of 2026, U.S. growth looks to remain steady at 2.1%, just above long-run potential for the U.S. economy.

With the workforce shrinking due to deportations and reduced immigration, labour productivity growth has become the sole driver of the U.S. economy’s supply-side expansion. Productivity rose 2.1% y/y in Q2, a bit faster than the quarter-century average. This is helping to contain inflation, by reducing unit labour cost growth to just 1.4% y/y, well below the 2% inflation target. This mild trend in underlying labour costs points to calmer inflation once the short-term effects of tariffs and higher fuel costs fade.

Alas, both are at risk of staying high or even moving in the wrong direction. The U.S. recently imposed new duties on Brazil, is in the thick of the trade battle with Canada (as previously noted), and recently replaced the expired Section 122 tariffs with the first tranche of more legally-defensible Section 301 duties of 10%-to-12.5% on 80 countries, which account for 99% of U.S. imports. This will keep the average U.S. tariff rate above 11%. This won't make the Fed's job of restoring price stability any easier.

As expected, the FOMC stood pat on July 29, despite repeated pledges to restore price stability, although three members dissented in favor of tightening. The futures market still sees one Fed rate hike by year-end, suspecting that more policymakers will lose patience with inflation hanging above the target for five years. However, we still expect the Fed to remain patient so long as core inflation shows steady progress toward the target. In fact, the Fed’s preferred measure of underlying inflation is poised to move back down to near 3% in coming months. We expect the core rate to slip into the low-2% range by spring 2027, assuming the effects of higher energy costs and tariffs fade. This could pave the way for two quarter-point rate cuts by the Fed late next year, shifting policy from a mildly restrictive stance to a more neutral setting.