Tariff rollercoaster ride continues
For a comprehensive (and not-too-horrifically-stale) take on the overall tariff environment – from motivations to scenarios to expected retaliation to implications – please refer to the video we recorded on February 4. It was put together after tariffs on Canada and Mexico were delayed, but before more recent steel and aluminum tariffs were announced – which are discussed below.
With the usual caveat that any analysis of tariffs runs the distinct risk of aging like milk rather than wine given the rate at which the situation is evolving, here are the latest tariff developments and our thoughts.
Tariff developments
The original 25%/25%/10% scenario
Canada and Mexico managed to defer threatened 25% tariffs from the U.S. on February 3, mere hours before the tariffs were set to be applied on February 4. The official delay is at least 30 days, making March 6 a date of potential interest.
To secure this delay, Canada will proceed with its prior commitment to invest a further C$1.3 billion into border security, it has agreed to appoint a new “fentanyl czar” and joins the U.S. in creating a new “strike force” to combat organized crime, money laundering and drug trafficking. Mexico promised a further 10,000 National Guard troops for its border.
Conversely, the U.S. acted on its 10% tariff threat against China. As a result, the overall average U.S. tariff rate on China rises from approximately 19% to 29%.
China has retaliated with a smaller set of tariffs that took effect on February 10. These include new 10-15% tariffs on U.S. energy and agricultural equipment. China is also stepping up its investigations into U.S. technological firms, announcing anti-trust investigations into Google’s and Apple’s app stores, alongside a pre-existing investigation into Nvidia. China also blacklisted a number of smaller U.S. companies. Finally, China is imposing additional export controls on its sale of tungsten and other critical metals to the U.S.
A meeting had originally been scheduled between Presidents Trump and Xi last week, but this was reportedly delayed. The White House has explicitly linked China’s tariffs to the country’s role in supplying the U.S. with the illegal drug fentanyl, and so the potential for these tariffs to be lifted theoretically exists.
New steel and aluminum tariffs
Over the past weekend, President Trump signaled his intention to impose 25% tariffs on all steel and aluminum imports. The executive order was then signed on Monday February 10.
This announcement rhymes with his first term, when a 25% steel and 10% aluminum tariff was levied in March 2018 and then resolved on a piecemeal basis as individual countries struck deals with the U.S. It took 14 months for these tariffs to be removed for Canada and Mexico. Despite this track record, we would flag a larger risk this time that these tariffs persist indefinitely – in line with our anticipated partial tariff endgame.
Canada is by far the largest exporter to the U.S. of steel and aluminum (see next chart). Canada sold US$13 billion in steel to the U.S. in 2024, and US$9.5 billion in aluminum. By way of comparison, Mexico was the second largest steel exporter at US$6.5 billion, with Brazil and China fairly close behind. For aluminum, no other country comes even close to comparing to Canada. The second most important country (the United Arab Emirates) sells nearly eight times less of the product to the U.S.
Canada dominated aluminum exports to U.S. in 2024
The affected countries will presumably retaliate. They’ll start with tariffs on any steel and aluminum imported from the U.S., and then augment this with other products to reach a roughly proportional impact. The largest response should presumably come from Canada, which happens to have loaded tariffs of the same approximate total magnitude (C$25 billion of targeted U.S. exports) into its muzzle last week. Some of the items on the list will be removed to make room for steel- and aluminum-targeted tariffs. These had previously been put on hold until Canada’s phase 2 response to blanket tariffs.
We very loosely estimate that these tariffs plus reciprocation, if indeed implemented and held in place, will subtract on the order of 0.2% to 0.3% from Canadian economic output. The damage to the U.S. is on the order of 0.1% to 0.2% of GDP (gross domestic product).
What’s next?
Tariffs threats are also brewing on other fronts.
From a geographic standpoint, the European Union (EU) seems particularly vulnerable based on recent Trump comments. While no one country in Europe is in the top three of U.S. trading partners, the EU collectively consumes more U.S. products than does the official leader, Canada (see next chart). The EU also maintains a trade surplus with the U.S., meaning it exports even more than that.
Trump tariff targets are U.S. top export destinations
The U.S. could conceivably seek concessions from Europe in the form of more military spending. Germany, France and Italy each spend less than 2% of GDP on defense. The U.S. may also pursue other objectives:
fewer trade barriers (the EU levies a 10% tariff on U.S. vehicles, versus just 2.5% on European vehicles entering the U.S.; the agricultural sector is heavily protected)
fewer regulatory barriers
perhaps the elimination of the digital services tax maintained by some countries.
Strong candidates for sector-level tariffs from the U.S. toward Europe include the auto sector, agricultural products, pharmaceuticals and industrial machinery.
With more of a global focus, President Trump is also clearly focused on sector-specific tariffs that span all trading partners. Steel and aluminum are the most obvious target, as per recent announcements. Other products that have been mentioned in this context include copper, oil and gas, pharmaceuticals, and semi-conductors.
President Trump has also recently spoken repeatedly about “reciprocal tariffs” – applying symmetrical tariffs on countries that disadvantage certain U.S. exports. In other words, tariffs would be used as punishment for other countries that themselves maintain trade barriers against the U.S. Presumably the endgame would be to get these foreign trade barriers removed, allowing U.S. reciprocal tariffs to be lifted as well.
Europe figures particularly centrally in this analysis. It has put substantial regulatory barriers in place (limits on genetically modified organisms and hormone-treated meat, stricter chemical rules, divergent technical standards, preferential domestic procurement), and the aforementioned tariffs on U.S. vehicles. Europe also has tariffs on dairy, meat, textiles, apparel and footwear. European agriculture is also heavily subsidized, though this is not entirely unique to the continent.
Interestingly, and despite a long history of high tariffs against U.S. products, Japan presently levies no tariff against U.S. vehicles and minimal agricultural tariffs, rendering it a less obvious target in this context despite a significant trade surplus with the U.S.
Purpose of tariff threats
We view U.S. tariff threats as both a negotiating strategy and a means to an end. The negotiating strategy is, of course, to make a maximal threat that can then convince a trading partner to make concessions (whether on trade matters or other policy fronts). The tariffs need not persist or even be applied to achieve this end. That was largely the attitude toward tariffs in 2017-2020, with China the one exception given substantially asymmetric trade relations with the U.S.
The concept of tariffs as negotiating strategy is still an important idea for 2025-2028, and many countries are likely to end up with only small, targeted tariffs.
But, to a greater extent than in 2017-2020, tariffs this time are also a means to an end. Tariffs are being viewed as an important revenue source to partially finance tax cuts, as a means of shielding American businesses from foreign competition, and part of an effort to make the U.S. more self-reliant. Most of these goals are not GDP-maximizing, but they do argue that tariffs are more likely to stick around this time, if not in a blanket 25% fashion.
Tariffs via game theory
Are President Trump and the affected nations deploying game theory effectively? The jury is mixed depending on what aspect of game theory one cares to consider. But, in general, one might say that Trump’s approach is sub-optimal if still fairly effective, and the targeted countries are largely adhering to optimal game theory.
Game of chicken
The game of chicken involves making tariff threats and hoping the opposing country blinks first – for example, making concessions before the painful tariffs are actually applied. To the extent the targeted countries are planning retaliatory tariffs of their own, this can hardly be defined as “blinking.” Then again, these countries did make some concessions to the U.S. in 2017-2020, and several have already made minor concessions to the U.S. this time.
Threat credibility
A key game theory concept is that to be fully effective, threats must be credible. Trump’s tariff threats are somewhat credible given that he has a history of implementing tariffs. But his credibility is partially diminished after repeated delays to the threatened tariffs and given that most tariffs from his first term did not persist. As such, other countries are likely to be somewhat less inclined to make major concessions to the U.S.
Brinksmanship
By publicly announcing his plan to implement tariffs, Trump has arguably ratcheted higher the pressure on other countries since in theory he should be reluctant not to follow through on a publicly announced plan. At least that’s how it would work for an ordinary politician who might be held to account by voters or political peers. However, President Trump seems not be damaged by the many policy balloons that he floats and then doesn’t implement. As a result, these verbal pronouncements apply less pressure than otherwise, weakening the power of brinksmanship in convincing targeted nations to make concessions.
Repeated games
When opponents encounter each other more than once via repeated games, their reputation becomes important and they have an incentive to cooperate. International trade is certainly a repeating game. As such, the U.S. should be incented not to impose tariffs on its neighbours, or if it does, it should believe that there are large advantages to be gained that outweigh the effects of the lasting antagonism that may result from the other countries. It is not clear that the gains are large enough for the U.S. here, but that is a matter of debate. The reality of a repeated game also incentivizes the targeted countries to engage in tit-for-tat behaviour, punishing the U.S. so that the U.S. does not continue to behave in the same way in the future.
Conclusion
The overall game theory conclusion is that President Trump is enjoying some success according to game theory, but probably shouldn’t make tariff threats beyond what he is willing to administer and should consider the long-term reputational ramifications. Other countries are largely behaving optimally, responding symmetrically to U.S. tariffs.
U.S. policy sequencing
It is notable that during President Trump’s first term, tax cuts came first, followed by tariffs. This meant that economic growth was front-loaded, with tax cuts boosting growth before tariffs later slowed it.
The setup in his second term appears to be the opposite. Tariffs are being implemented right out of the gate, with tax cuts likely to take somewhat longer to implement. The most logical timing for tax cuts is toward the end of this year, because that is when existing tax policy otherwise reverts to higher rates. Passing a tax bill before then wouldn’t have a large effect since the bulk of the effort is to prevent an effective tax hike that hasn’t yet taken place.
The consequence of this is that growth might be a bit slower than otherwise over the next few quarters, before picking up in 2026.
But we wouldn’t put too much weight behind this, as there are so many other swirling forces in play – including near-term tailwinds such as the lagged effect of earlier Fed rate cuts, a positive wealth effect after recent stock market gains, reviving animal spirits, and the additional liquidity supplied by the draining of the Treasury General Account. As a result, our own growth profile doesn’t anticipate particularly weak growth in the near term.
Policy constraints
Amid bold tariff proposals, it is useful to step back for a moment and recognize that there are a variety of political, practical and legal constraints on what U.S. public policy is likely to deliver over the coming years.
To be sure, the political alignment behind the White House is strong, with a Republican sweep in Congress. But the Republican majority is fairly slight in both chambers, with the implication that it would not take a large amount of dissent to limit the scope of legislation over the coming years. Such dissent already exists to some extent, explaining why a single large omnibus bill has not yet been implemented.
Practical constraints also limit policy. As an example, it isn’t realistic to think that the entirety of the undocumented residents in the U.S. can be located and deported given available manpower, or that it would be desirable to reduce the U.S. population by nearly 5% in short order. As a result, it is unlikely that the maximalist form of this policy will be executed.
That still leaves plenty of scope for bold and unconventional policies in the years ahead, but it isn’t quite carte blanche for the executive branch.
Finally, there are legal constraints, even with a Supreme Court presently configured in a conservative direction. Already, judges have blocked – in some cases temporarily – various White House initiatives. Two prominent examples that have been blocked are the effort to end birthright citizenship and the Department of Government Efficiency’s access to Treasury payment systems.
That still leaves plenty of scope for bold and unconventional policies in the years ahead, but it isn’t quite carte blanche for the executive branch.
Revisiting the tariff outlook
There remain quite a number of different directions tariffs could go, as demonstrated by the blizzard of tariff ideas put forth over the past few weeks.
On the whole, it seems advisable to take tariff threats seriously. The danger is indisputably greater than in 2017-2020 given Trump’s increased clout combined with his desire to fund tax cuts with tariff revenue. We budget for an increase in tariffs over the next year, even if the most likely scenario is arguably for smaller targeted tariffs (“Partial tariffs” scenario in the following table):
Possible tariff scenarios: We budget for an increase in tariffs over the next year
While blanket 25% tariffs are unlikely in our view, that threat has technically just been deferred by a month for Canada and Mexico, rather than eliminated altogether. There may be white-knuckle moments again in early March. In a best-case scenario those tariffs would be definitively cancelled as an economic deal is struck. In a worst-case scenario, the tariffs would simply be applied. In a middle-of-the-road scenario, the tariffs might be deferred by another month, or perhaps for longer, as negotiations continue.
Reasons for moderation
To summarize the arguments for a more moderate set of tariffs:
President Trump famously begins negotiations with a maximum threat, only to pivot in a more moderate direction.
President Trump indicated that trade negotiations with Canada and Mexico will now be passed to the technocrats – his Treasury Secretary, Commerce Secretary and Secretary of State. That improves the scope for an economic deal being struck that cancels a significant fraction of the proposed tariffs.
The U.S. doesn’t want to suffer major economic damage or to experience higher inflation, which sustained tariffs would bring.
Practically speaking, a 25% tariff levied on Canada and Mexico would result in a great deal of screaming from the integrated North American auto sector and its hundreds of thousands of workers.
There are political, practical and legal constraints to tariffs. A key legal angle is the extent to which tariffs can be justified for national security reasons. Judges may object if the interpretation is so broad that it encompasses every possible good.
It is promising that President Trump is already shifting his attention to sector-level tariffs, which should do less overall economic damage.
Enhanced forecast considerations
With time, we are able to do more and better modelling of the effects of tariffs. Here are four new considerations.
Unemployment impact
First, we can estimate the effect of various tariff scenarios not just on GDP and CPI (Consumer Price Index), but also on unemployment. Using an Okun’s coefficient of 1.5, we figure that the worst-case tariff scenario for Canada (“North America-focused tariffs”) would increase the unemployment rate by approximately 3 percentage points (ppt), lifting it to nearly 10%. A more likely scenario (“Partial tariffs”) would increase the unemployment rate by about 0.2ppt, all else equal.
For the U.S., that same worst-case scenario would increase the unemployment rate by about 1ppt. The more likely scenario of partial tariffs would instead increase it by just 0.1ppt to 0.2ppt.
Uncertainty damage
Most econometric models do not budget for economic damage from policy uncertainty. But such uncertainty is clearly quite high right now as various tariff proposals pop into and out of existence. One could easily imagine that businesses on the cusp of making major capital investment decisions opt to delay those decisions.
From a geographic standpoint, the clear danger from policy uncertainty is to non-U.S. markets. If a company is already planning on expanding its operations in the U.S., it will likely continue on that path given the large U.S. domestic market – unless the plant is expected to export significant quantities of the product. Conversely, expansion decisions in other countries – which in many cases are counting on being able to export friction-free into the U.S. – are much more in doubt. Even though we expect most sectors to emerge largely unscathed from tariffs, genuine and lasting damage can be done, and this could be the straw that breaks the camel’s back in favour of shifting to U.S. production.
Thus, the danger is that all affected economies suffer a bit more near-term economic damage than most models would imply given the erratic way tariffs have been proposed. Further, it is possible that non-U.S. markets experience somewhat more long-term damage – not necessarily of relevance over the next year or two, but certainly beyond.
Elasticity of supply and demand
We can also advance one step beyond conventional economic models by accounting not just for the ordinary volume of trade that transits between countries, but also the extent to which demand for those products is elastic or inelastic.
Using the U.S.-Canada relationship and the possibility of tariffs between the two, it is relevant that – at least in a stylized sense – U.S. demand for Canadian imports tends to be more inelastic, whereas Canadian demand for U.S. imports tends to be more elastic.
The U.S. imports a disproportionate quantity of necessities in the form of natural resources from Canada such as oil and agricultural products. Demand does not vary easily for these products. In contrast, Canada imports a more varied mix of products from the U.S. that tend toward more discretionary items such as consumer products. Demand is therefore more sensitive to price movements.
The net result is that the burden of U.S. tariffs on Canadian products should be tilted slightly more than usual toward U.S. consumers as they will continue to purchase the product even at a higher price. In contrast, Canadian tariffs are applied in a way that should tilt the burden slightly more than usual toward U.S. producers.
The mismatch is further magnified by the fact that Canada proposes to levy tariffs on U.S. products for which Canadian demand is especially elastic and for which substitute products exist. In contrast, U.S. blanket tariff threats and proposed steel and aluminum tariffs make no such distinction.
The net result is that the burden of U.S. tariffs on Canadian products should be tilted slightly more than usual toward U.S. consumers as they will continue to purchase the product even at a higher price. In contrast, Canadian tariffs are applied in a way that should tilt the burden slightly more than usual toward U.S. producers. On both sides of the border, the U.S. takes a slightly greater hit.
This analysis likely also applies to Mexico, though the effect on U.S.-European trade is probably more neutral, and the effect on U.S.-China trade theoretically disadvantages China more (and the U.S. less) than a conventional model would indicate.
To be clear, this is all at-the-margin thinking, but the point is that – in the worst-case scenario of 25% blanket tariffs between the U.S. and Canada and Mexico, it might be prudent to take the “over” on the presumption of a 1.5% hit to U.S. GDP and the “under” on the presumption of a 4.5% hit to Canadian GDP.
Long-term damage
Looking beyond the next few years, the potential for long-term damage from tariffs is not trivial. If countries conclude they cannot count on the U.S. as a trading partner, or even as a partner in a non-economic capacity, the scope for both international and U.S. damage is considerable.
Countries could seek to diversify to other trading partners, weakening U.S. trade ties and strengthening alliances elsewhere. This would have growth-negative implications for the U.S., growth-positive implications for new partners, and overall negative global implications as trade is dictated less by the principle of relative advantage and the magnetic pull of geographic proximity, and more by political considerations.
In an extreme scenario, the world’s top entrepreneurs, executives, academics and corporations – who presently cluster in the U.S. – could eventually conclude that the U.S. and its gyrating public policies, volatile politics and diminished access to international markets is no longer the right place to start/operate that next world-beating company or educate the next generation of workers. This would be greatly to the U.S. disadvantage, and to the advantage of wherever those exceptional individuals and companies turn. The entire global order could be altered. The U.S. would suffer from a higher risk premium in its bond market if it were viewed as a less reliable partner, and if another country managed to claim reserve-currency status.
For all of that, it is important not to overreact. The temptation is to think “this time is different” far more often than is truly the case. Trade policy could well normalize in a year, or in four years. Trade ties are dictated significantly by geography, and that will likely prove difficult to overcome despite efforts to diversify trade. On a related note, there have been prophecies that the U.S. political schism will be the downfall of the U.S. for decades, and yet the country remains the beating heart of economic dynamism, risk premiums are fairly low and trust between businesses is high. But the risk of long-term damage is rising.
Who’s fault are trade deficits?
A key tenet of the current White House’s trade policy is that U.S. trade deficits are a) the fault of the countries running a surplus with the U.S. and b) unfair. While it may not be desirable to run a large trade deficit indefinitely, the truth is arguably more nuanced.
First, it takes two to tango. Every international exchange is voluntary – no one is forced to participate. Furthermore, by definition, each transaction benefits both parties or they wouldn’t deign to participate. The principle of “relative advantage” means that the gains from trade can be found nearly everywhere. It isn’t necessary that one country be better at making one product and another country be better at making another – advantage is instead gained even when one country is more efficient at making every possible product, so long as it is relatively less superior at making one thing and relatively more superior at making another.
Second, a trade deficit also reflects dissaving in an economy. By definition, running a trade deficit means a country is actively borrowing from the rest of the world, and a trade surplus means it is actively saving. While that hardly makes a trade deficit more appealing, the point is that a country cannot eliminate its trade deficit unless it also opts to save more. Thus, a country can hardly place all of the blame for its trade deficit on foreign actors.
Third, the country with the world’s reserve currency is theoretically more inclined to run a trade deficit. That happens to be the U.S. in this era. The mechanics are that foreign countries, companies and individuals want a certain amount of a safe, liquid assets. Those are largely held in U.S. dollars today. By purchasing U.S. dollars, the currency becomes overvalued. When the currency is overvalued, imports are cheap and exports are expensive. In turn, the U.S. is inclined to import more and export less, resulting in a trade deficit. This is not easily overcome unless the U.S. wishes to forgo its reserve currency status.
Fourth and finally, while these persistent trade deficits do mean that the U.S. is borrowing from the rest of the world and/or the rest of the world is acquiring a growing stake in U.S. assets, this has not actually been painful for the U.S. Normally, you would worry about all of the money spent servicing that foreign debt, and all of the dividends paid out to foreign investors holding U.S. securities. But, as it happens, foreign investors tend to buy a lot of U.S. Treasury debt, which provides a low investment return. Meanwhile, the American money that does go abroad tends to buy higher-returning assets, like companies.
In turn, although the U.S. current account balance has been in uninterrupted deficit since the early 1990s, the U.S. investment income balance has been improbably positive over the entire time period, right up until the last few quarters when it dipped into slightly negative territory (presumably due to how high U.S. yields are now). Even with the new investment income deficit, it is still one heck of a deal given the size of U.S. liabilities to the rest of the world (see next chart).
U.S. has long maintained an investment income surplus despite a current account deficit
The conclusion is that the trade deficit isn’t especially the fault of foreign countries, nor has it even been much of a problem for the U.S.
Canada’s tariff response
When Trump’s 25% tariff plan for Canada was mere hours from fruition, Canada responded by articulating its own plan for countervailing tariffs. The first step would be to target C$25 billion in U.S. products with a 25% tariff, focusing on politically sensitive products for which Canadian demand is elastic and substitutes exist.
The second phase was set to arrive three weeks later, with another C$130 billion in tariffs on U.S. products. After that, just under half of U.S. imports would be subjected to the 25% tariff, meaning it wouldn’t quite be a tit-for-tat response. Of course, none of that is now on the table given the delay of the 25% tariff, though a version of the first phase could be recycled in response to the steel and aluminum tariffs, as discussed above.
Now that the 25% blanket tariff has been delayed, the focus shifts to negotiations. The U.S. may seek concessions on a variety of fronts. It will be up to Canada to determine which of these are on the table for negotiations:
Canadian border security
Canada’s defense spending
Canada’s unpopular digital services tax and perhaps the Canadian Content Contribution tax
Canadian protectionism, such as supply management industries and perhaps protected service-sector industries
The ever-controversial softwood lumber sector
Assistance in weakening the overvalued U.S. dollar
Canada to purchase more U.S. goods
Reopening the USMCA early
National unity
Canadian national unity has been strengthened by U.S. threats. It will be fascinating to see whether this lasts.
So long as it does, it appears to have put the incumbent Liberal government in a more favourable light with voters, as polls reflect a partial revival of the party’s fortunes. The Liberals still substantially trail the Conservatives, however, with an election approaching later in the year.
The potential for new nation-building projects is certainly higher than it has been in some time.
The most acute problem is that the time frame for securing this additional output is far slower than the pace at which damage from U.S. tariffs would accumulate, so it isn’t realistic to think that one force can symmetrically offset the other.
One newly popular option is to reduce provincial barriers to trade. A study by the International Monetary Fund estimated that the Canadian economy is 4% smaller than it would otherwise be due to provincial barriers – the equivalent of a whopping 19% tariff.
Realistically, there are quite a number of impediments to this, though it is nevertheless worth pursuing. The most acute problem is that the time frame for securing this additional output is far slower than the pace at which damage from U.S. tariffs would accumulate, so it isn’t realistic to think that one force can symmetrically offset the other.
Furthermore, this isn’t a new idea. Politicians have been talking about it for ages, and even made a sizeable step forward in 2017 with the passage of the Canadian Free Trade Agreement among provinces. And yet the barriers largely remain.
That’s because the interprovincial barriers aren’t as simple as a 19% tariff that can be lifted with the stroke of a single pen. Instead, the barriers are largely accidental, living in the realm of provincial variances in permits, licensing, technical standards, safety certifications, government procurement rules and securities regulators.
A major initial opportunity might be to harmonize transportation rules across the country to allow the smoother physical flow of goods.
A big part of the theoretical opportunity for improved productivity is by synchronizing the rules governing three main sectors: utilities, healthcare and education. What is essentially being asked is that provinces give up their sovereignty over such matters, and instead hand them to the federal government. The provinces would have little left to control if this was taken to its logical extreme. Ceding power is never popular with politicians.
The modelling that’s been done on the potential gains from more interprovincial trade also expect people to move from low productivity areas to high productivity ones – also not necessarily a popular idea with significant swaths of the country.
As a result, expectations need to be realistic. Western Canadian provinces have already set an example, lowering some barriers amongst themselves. Eastern Canadian provinces would do well to copy this. A major initial opportunity might be to harmonize transportation rules across the country to allow the smoother physical flow of goods.
The threat of tariffs has seemingly increased the motivation to pursue what were previously unpopular ideas.
Beyond the realm of provincial trade barriers, there is great potential in committing to physical projects that connect Canada together and allow for the opening of non-U.S. foreign markets. These are unlikely to be delivered with sufficient speed as to buffer the initial pain from tariffs (both in the context of the initial burst of capital expenditures and the enhanced productivity and markets opened up later). But they could still be worthwhile in their own right, and the threat of tariffs has seemingly increased the motivation to pursue what were previously unpopular ideas.
The obvious options are to revisit some of the pipelines that were proposed (and rejected) a decade ago, stretching from Alberta to eastern Canada, west across the Rockies, and possibly even north to the Arctic Ocean. The expansion of ports, natural gas terminals and the like should be reconsidered as well. Seeking to process more of Canada’s raw materials at home could also be pursued if economically viable. Perhaps there is room to enhance and winterize the St. Lawrence Seaway in a manner that would provide further access to international markets for central Canada.
Economic data remains good
The U.S. economy continues to tick along. Some economic indicators are emitting signs of outright strength, while others are more pedestrian. Overall, the mix is consistent with further moderate growth, which is close to the ideal for an economy already bumping against its capacity limits.
At the optimistic end of the spectrum, the Institute for Supply Management (ISM) Manufacturing Index leapt from 49.2 to 50.9, surfacing into growth mode for the first time in many months. This is the highest level for the Index since September 2022 (see next chart). Its twin, the ISM Services Index, slipped slightly, but remains consistent with decent growth and is in the realm of the trend established over the past few years.
U.S. Institute for Supply Management indices look solid
U.S. Q4 GDP may have landed somewhat below the initial expectations. It shows +2.3% annualized growth in the fourth quarter. This contrasted with expectations for a 3%-plus gain, but is a perfectly respectable rate of growth. Critically, the contribution from the all-important consumer was a robust +4.2% annualized growth.
U.S. payrolls for January slightly missed the consensus expectation, with +143,000 jobs versus 175,000 expected. But in actuality the report was more than adequate, and if anything continues to flag the risk of too much economic growth. As a starting point, job creation on the order of 100,000 to 200,000 per month is probably the sustainable sweet spot, with slowing population growth increasingly arguing you want to be in the bottom half of that range. Mission accomplished.
Revisions of +100,000 additional jobs over the prior few months added to the strength of the report, as did the fact that the unemployment rate fell from 4.1% to 4.0% -- the low end of the 4.0-4.5% range that we think represents an equilibrium level. Furthermore, estimates from the San Francisco Federal Reserve pointed to the possibility that adverse weather conditions artificially subtracted 80,000 to 90,000 jobs from the January report, arguing it might have been well into the 200,000-plus zone otherwise. Hourly earnings also picked up slightly, to +4.1% year-over-year (YoY). The takeaway is that the job numbers were a bit too hot, not a bit too cool.
The Fed opted to pause in the 4.25-4.50% range for the fed funds rate in January. Based on the data that has since come out and the potential for a fairly robust CPI report in January (based on higher oil and the trajectory of real-time inflation metrics), rate cuts appear unlikely in the near term. Markets don’t price in a greater than 50% chance of a U.S. rate cut until June, and don’t fully price in a rate cut until September. For our part, we now anticipate an unchanged fed funds rate over the entirety of the year, though there are certainly scenarios in which cuts become necessary – much as there are now scenarios in which a rate hike could manifest.
Canadian data turns upward
We continue to flag a firming in the tone of Canadian economic data. The January job numbers were strong for a third consecutive month, delivering an additional 76,000 jobs. This is all the more impressive in the context of slowing population growth. The details were also good, with 57,000 new private-sector jobs, hours worked that rose a whopping 0.9% month-over-month (MoM), and an unemployment rate that accordingly fell to 6.6%. That’s down 0.3ppt from the earlier 6.9% peak.
Unlike in the U.S., Canada’s declining unemployment rate and strong job creation are unambiguously welcome developments, as the economy suffers from some economic slack that this helps to partially close.
The Canadian consumer is also looking somewhat better. The Bank of Canada’s Survey of Consumer Expectations from the fourth quarter of last year found that consumers are feeling better about their financial health. This is largely due to declining interest rates. Of those with mortgages – a potentially precarious group as a large cohort of borrowers face mortgage resets in 2025 and 2026 – fewer expect their new mortgage payment to be higher than the old one, and those expecting a higher mortgage payment appear confident they can afford it. Consumers also articulate increased – albeit still cautious – plans to raise their spending on durable goods, vacations and restaurants. The appetite to purchase a home is also rising.
Because economic slack nevertheless persists and Canada’s inflation rate is already on target, the Bank of Canada was able to again cut its policy rate, from 3.25% to 3.00% in late January. Considerable tariff uncertainty now blurs the forward-looking picture. The default assumption is another 25-basis-point rate cut on March 12, but major tariffs could increase the magnitude and/or accelerate the timing.
But we warn against expecting too much in the way of inter-meeting rate cuts from the Bank of Canada. A 25% tariff might be levied one day and lifted the next, leaving the Bank of Canada in an awkward position if it had cut rates in response to the initial tariff move. It might be savvier to wait for a period of a few weeks and then adjust policy once there is greater evidence that a tariff has truly stuck (or not)
Keeping an eye on artificial intelligence developments
This is a time of remarkable advances in artificial intelligence, with the verb “ChatGPT it” rapidly supplanting its predecessor “Google it”. The scope for further gains is enormous, though the rate of improvement has been highly uncertain.
Delivering a resounding vote for team “rapid improvement,” Chinese AI model DeepSeek recently stunned the world by announcing, from a little-known player, a model that seemingly delivered a performance that is as good or better than the top existing Large Language Models, but at a greatly reduced cost and resource intensity.
It would seem that some of the old AI theories and techniques from decades past that had initially been unworkable with prior generations of hardware and software are now becoming viable, allowing models to improve not just on the basis of incremental advances in hardware, but also via smarter use of the hardware. DeepSeek’s primary achievement appears to have been at least one such advancement: rather than feeding queries through the whole AI model – a highly resource-intensive action – the DeepSeek model uses a novel Mixture-of-Experts approach. This is to say, it has a component that evaluates queries and then reroutes them to specialized subsystems that can best handle that particular query, without taxing the overall system.
Negative implications
A variety of negative investment implications extend from this advance, explaining why certain segments of financial markets sold off in response to the news. The greater efficiency of the new model argues that the insatiable demand for expensive cutting-edge computer chips could be reduced.
The valuation of other companies that have developed leading AI models also fell on the realization that the space is more crowded than previously realized. The incumbent models may not even be at the forefront of technical developments, and dark horses are still capable of popping up despite the massive capital expenditures that had previously been presumed to provide a deep moat for the sector.
Utilities that generate electricity also theoretically suffer. AI is expected to be a key driver of electricity usage going forward, and more efficient models theoretically reduce that demand.
Positive implications
But the positives certainly outweigh those negatives. Critically, from an economic standpoint, any technological advancement such as this helps to increase productivity, making economic growth faster and creating wealth. As new techniques are applied to AI, the scope for further large advances in the near term is elevated.
All the companies that create software that sits on top of the AI models and the companies that purchase AI services benefit from stronger AI.
Carbon emissions are theoretically reduced if new AI models become less power-hungry.
Finally, China looks better. At a time when the country has been experiencing unfamiliarly slow growth for a variety of reasons that include a seeming de-prioritization of the private sector and possibly the innovation that usually sprouts out of it, the DeepSeek model argues that China is not too far from the cutting edge in Large Language Models, despite a significant disadvantage in its access to bleeding-edge chips. Some have taken to calling this China’s “Sputnik Moment”. That’s probably something of an exaggeration, but the takeaway is that China is indisputably still a place of innovation, especially when considered alongside the country’s role at the forefront of electric vehicles, batteries, trains, solar power and drones.
Expectations may be overblown?
It is certainly exciting that AI models continue to advance rapidly, as the potential productivity implications are massive. But the specific excitement over the DeepSeek development may be somewhat overblown. The notion that the model was built for US$6 million and with a pittance of computer chips versus the billions spent on other models is probably not quite right – that was likely the cost for the final training run, which built upon the herculean efforts of others.
The DeepSeek advance represents incremental innovation and can be reverse-engineered with unusual haste given the open-source format of the project. The big spenders are still most likely to win the AI race. Indeed, there are reports that OpenAI is now in safety testing for its next big model release, and that this new model has at least a comparable performance to DeepSeek while operating at a speed that is a startling 5.5 times faster.
Lastly, thoughts that the demand for computer chips and electricity will be lower due to the efficiency gains seemingly achieved by DeepSeek may also prove unrealized, as the now ubiquitous Jevons Paradox argues that while the resources required for individual AI queries may decline, this will spur additional demand for such queries in a way that could leave overall appetite for chips and electricity and the like higher than it was before. As such, capital expenditures on computer chips and on AI models are unlikely to decline.
Adding up damage from Los Angeles fires
Now that Los Angeles fires have been mostly snuffed out, we are in a position to make some economic comments.
The Los Angeles metropolitan area is the second largest city in the U.S, both according to population (12.7 million people) and GDP (approximately US$1.3 trillion in annual output). That puts Los Angeles at around 5% of the entire country’s GDP.
The damage inflicted by the tragic fires resembles that of other natural disasters, with major financial losses and a temporary decline in output, followed by a subsequent rebound as that temporary loss is restored. Finally, there are long-term rebuilding implications. On the aggregate, the damage appears to be several times smaller than the two hurricanes that struck the U.S. southeast in quick succession in the fall of 2024.
Providing some sense for the scale of the damage, 186,000 of the city’s 12.7 million people are believed to have been significantly affected by the fire – that’s 1.4% of the population. Of the city’s approximately 4 million structures, 16,244 were destroyed – just 0.4%. This isn’t to trivialize the very real consequences of the properties destroyed, but it nevertheless represents a very small share of the overall housing and building stock. Power outages temporary affected a peak of about 300,000—400,000 homes, representing 7.5%–10% of the total.
From a damage perspective, the financial losses are outsized relative to the number of properties destroyed given that home prices are high in Los Angeles, and some of the affected areas had especially high home prices. Estimates of insurance losses vary from about US$20 billion to US$45 billion. By way of comparison, Hurricanes Helene and Milton collectively inflicted insured losses of about US$140 billion last year. The Los Angeles figure probably underestimates the total damage as an unusual fraction of properties may not have been insured due to high insurance costs.
One source estimates a 20,000 to 40,000 hit to Los Angeles employment in January, which is less than 1% of the city’s total jobs. Some fraction of the lost jobs won’t soon return, but over time additional construction employment can probably more than offset this.
The decline in Los Angeles’ economic output was probably several times that on a percent basis, but only temporarily and with the rebound likely now already mostly complete. The national economy might have grown about 0.1% to 0.2% less quickly in January, with the effect on first-quarter national GDP likely no more than a few tenths annualized. In contrast to a hurricane, where devastation is spread widely, power outages are nearly universal and roads are often impassable, the effect of the LA fires was much more concentrated and thus limited.
From an inflation standpoint, there are three forces to consider. The first is that a weaker economy tends to be deflationary. However, the other two forces easily subsume this.
The fires likely resulted in temporary shortages – of food and essentials for those preparing for the worst, and of apartments, cars and other possessions for those who lost their homes. Another inflationary source is that insurance rates are likely to rise, most acutely in Southern California, but also across California and indeed to a lesser extent across the U.S. Insurance costs for motor vehicles, tenants and households are a significant 3.2% of U.S. CPI and were a material contributor to high inflation in recent years. Incrementally higher inflation, even at the national level, is likely.
-With contributions from Vivien Lee, Aaron Ma and Ana Ardila
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