Commentary

North America Macroeconomic Update: On-and-Off Tariff Policy Weakens the Outlook

Sovereigns

Summary

Morningstar DBRS released its semiannual North America Macroeconomic Update. The U.S. and Canadian economies held up reasonably well during the first quarter amid rising trade tensions. Growth concerns took a turn for the worse in early April with the announcement of Liberation Day tariffs and trade tensions intensifying between the U.S. and China. Subsequent de-escalatory measures have, at least temporarily, diminished the severity of the tariffs' initial shock. However, we expect U.S. policy uncertainty to remain elevated going forward and act as a drag on growth in the second half of 2025.

Key highlights include:

-- With on-again-off-again policymaking, we anticipate that consumers will continue to spend but at a slower pace. The tariffs that are imposed will generate price increases in the coming months that will erode consumers' purchasing power. Some firms may defer investment until there is greater visibility on the economic outlook. If the U.S. administration pushes ahead with high and broad-based tariffs, the odds of recession later this year or early next year will materially increase.

-- Core inflation is running close to 3% in the U.S. and Canada. The initial effect of the tariff shock has been disinflationary, as diminished growth expectations quickly led to lower energy prices. However, we expect firms to pass some portion of the increased import duties on to consumers in the coming months.

-- We expect the Federal Reserve and Bank of Canada will take a wait-and-see approach in the second half of 2025. With inflation running above target and unemployment low, the Fed will likely remain non-committal regarding future monetary policy until there is greater visibility about the outlook for prices, activity, and expectations. The Bank of Canada will also take a cautious view to adjusting monetary policy. However, the BoC's approach largely reflects its starting position, as monetary policy settings are already in neutral territory.

"High frequency indicators in April and May painted a mixed picture, so the full impact of U.S. trade policy may not be evident yet," says Michael Heydt, Senior Vice President - Sector Lead, Global Sovereign Ratings. "But looking ahead, we expect ongoing policy uncertainty will negatively affect demand, and this - in addition to whatever tariffs are actually imposed - will weigh on growth across North America in the second half of the year."

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