By Douglas Porter, CFA, Chief Economist and Managing Director and Sal Guatieri, Senior Economist and Director, BMO Financial Group

Many of the major trading partners of the U.S., including biggies the European Union, Japan, South Korea, and the U.K., have managed to reach deal frameworks with the White House. Apart from the UK's 10% duty, the other regions were dealt levies ranging between 15% and 20%. They also pledged hundreds of billions of dollars in direct U.S. investments and purchases of American-made goods. Over 60 other countries were slapped with modified reciprocal duties ranging between 15% and 41%, while all other trading partners (including those that the U.S. runs trade surpluses with) face a minimum 10% base duty.

Of course, none of the tariffs are written in stone and all could change on a whim. Moreover, the U.S. courts could rule some of the tariffs illegal, though the Administration could still impose duties under a number of other trade acts. Importantly, the U.S. still needs to make deals with three more major trading partners: Canada (which remains in limbo), Mexico (which was granted a 90-day extension), and China (with a November 12 deadline looming). Meanwhile, the White House has also imposed 50% duties on select copper products, with investigations underway for eight other industries, including lumber, microchips, and medicines. The big picture is that we may only be in the middle innings of this game, with more curveballs to come. Businesses hoping for clarity before committing to hiring and investment decisions will need to wait longer.

What does this trade backdrop mean for the economic outlook? Starting with the United States, there are some signs of a slowing, first seen in so-called soft data and now being confirmed by the hard data. Most notably, employment has cooled considerably. Private nonfarm payroll gains averaged 80,000 in the past five months, the second-weakest pace (apart from the pandemic) since 2010. And, barring strong hiring in health care and social assistance, job creation would have nearly ground to a halt, as more industries join manufacturers as net job cutters.

While the unemployment rate has been little changed at 4.2% in the past year—essentially "full employment"—it’s been subdued by slower labour force growth due to the immigration crackdown. Weakening demand for and supply of workers are symptoms of a soft labour market. Lower labour demand is less a reflection of outright layoffs, which are about normal following earlier cuts to the federal workforce, and more due to stagnant hiring, which business surveys suggest partly ties to the chaotic trade policies. This has driven long-term joblessness to the highest levels (outside the pandemic) since 2017.

Modest growth will likely persist in the second half of 2025. With the average effective tariff rate on U.S. imports at almost 18%, versus just over 2% last year, economic growth is expected to be nearly 1 ppt lower this year than otherwise. This level of 'taxation' could generate nearly $400 billion in revenue for the government, but the cost will be partly borne by consumers. To date, businesses have been reluctant to fully pass tariffs onto customers for fear of losing market share (GM and Ford both reported near billion-dollar quarterly hits to earnings). Yet, companies can’t absorb these losses forever, especially now that the tariffs look to remain in place. Adding to the growth drag will be deportations, higher student loan payments for millions of borrowers, and the legacy of the DOGE cuts. All in, we project GDP growth of 1.7% this year, or more than 1 percentage point below last year’s rate and somewhat below long-run potential.

Even assuming trade tensions ease, economic growth will likely remain tepid in 2026 at 1.6%. A reduction in trade-related uncertainty could unlock delayed investments, fanned further by deregulation and the full and immediate expensing allowance provided by the One Big Beautiful Bill Act. Federal spending will also increase for defense and border control, but decline for health care, student loans, and food stamps. A budget deficit of almost 7% of GDP, unheard of outside of wars, recessions and pandemics, simply cannot not provide an economic lift.

Monetary policy also seems set to provide support. After cutting rates by one percentage point last year, the Fed has kept policy moderately restrictive due to “somewhat elevated” inflation, solid economic growth (until recently), and uncertain trade policies. Chair Powell’s recent remarks lean towards resumed easing. With the labour market softening, the Fed will feel compelled to look past any temporary tariff-led spike in inflation. And the reality is that amid all the noise around Chair Powell, his tenure is up in May/26, and the Fed will have a new, presumably dovish, Chair by next spring. Additional rate trims should bring the fed funds rate below 3% by the end of 2026, into mildly stimulative territory.

Turning to the Canadian economic outlook, Canada was slapped with a 35% “fentanyl” duty (up from 25%) while getting no break on sectoral levies. Still, the average effective tariff rate on its shipments to the U.S. rose only slightly to around 6%, as this duty applies only to a small share of goods (believed to be under 10%) that are non-compliant with the USMCA. Apart from steel and aluminum (50% duties) and motor vehicles (25%, though roughly halved by the U.S. content carve-out), most goods (perhaps more than 90%) continue to be shipped duty-free to the U.S. This is estimated to be the lowest effective tariff rate in the world. It is critical that Canada renegotiate the free-trade agreement during the formal review over the next year. If the U.S. were to walk away from the deal after six months’ notice, Canada’s economy could face a deep downturn.

We now suspect the Canadian economy will avoid a 'technical' (two-quarter) recession, by holding flat in Q3 before growing at a 1.5% annualized pace in Q4. Consumers are showing some resiliency, with retail sales holding up in the summer. Providing support are record equity markets, positive income growth, and lower borrowing costs. The latter is pulling debt service costs down from record highs and easing the pain of mortgage resets. Although joblessness is on the rise, this largely reflects earlier rapid population growth, which has since cooled. Net hiring has averaged 15,000 jobs per month this year, close to the long-run norm but a step back from 32,000 in 2024. Further support will stem from a trim to personal income taxes, the “Buy Canada” movement, and an upturn in international tourism amid stricter U.S. border controls. The economy should strengthen further in 2026, benefiting from lower interest rates, increased federal spending on infrastructure, housing, and the military, as well as financial support for tariff-affected industries. Initiatives to fast-track energy and mining projects and eliminate provincial trade barriers will also help. In all, real GDP is expected to grow 1.3% in 2025 and 1.4% in 2026, modestly below potential and last year's rate.

Despite slower population growth, home sales are turning the corner. Of course, market conditions still vary widely by location: buyers are in control in Ontario and B.C., dragging prices lower, while sellers rule across the Prairies, Atlantic Canada, and Quebec, where prices are setting new highs (notably in Quebec City, up a sizzling 15% y/y). Sales should get a modest fillip once the federal government passes legislation to reduce the GST on new homes for first-time buyers.

Headline CPI inflation remains low at just under 2%, partly due to the removal of the consumer carbon tax. But the underlying rate is running higher at around 2.5%, according to the Bank of Canada. Even so, we expect inflation to average around 2.0% this year and next, as rising unemployment offsets limited retaliatory tariffs. Labour market slack is already evident in the lowest job vacancy rate in eight years.

Elevated core inflation sets a high bar for another Bank of Canada rate cut. However, with unemployment expected to rise, we see the Bank coming off the sidelines this fall provided the next core CPI calms. Cumulative cuts of 75 bps by the spring of 2026 should take the policy rate down to 2.0%, deemed moderately stimulative. Should the Fed ease more than the Bank next year and assuming no major trade stumbles along the way, the Canadian dollar could rise modestly to 75 cents by late 2026.