The Bank of Canada says the United States’ tariffs pose a threat to global economic stability and could reduce growth and increase unemployment in Canada.
In the event of prolonged U.S. tariffs, and Canada’s subsequent counter-tariffs, the trade war could increase the risks to Canadian financial stability by hurting banks and other institutions while making it more difficult for households and businesses to manage their debt loads, the Bank of Canada said in its latest Financial Stability Report (FSR).
“In the near term, the unpredictability of U.S. trade policy could cause further market volatility and strains on liquidity. In an extreme case, market volatility could turn into market dysfunction,” Bank of Canada Governor Tiff Macklem said during a May 8 press conference on the FSR.
Macklem noted Canada’s financial system had weathered “unprecedented shocks” over the last few years due to the COVID-19 pandemic, high inflation, and supply chain issues, and it had “proven resilient.” But he said if the United States maintains its “dramatic protectionist shift” and the trade dispute is prolonged, it would have “important ramifications” for the financial system.
The U.S. has placed a series of tariffs on Canada, including 25 percent tariffs on imports not covered under the United States-Mexico-Canada free trade agreement, and similar tariffs on autos, steel, and aluminum. The U.S. also placed 145 percent tariffs on China and baseline “reciprocal” tariffs on imports from other countries, with many currently under negotiation.
Macklem said that the Bank does not know how long U.S. tariffs will remain in place, or whether they will be reduced as trade deals are made, making it “particularly difficult to anticipate the risks to the financial system.”
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Macklem said that in Canada, which still has high levels of household debt, some may be unable to keep up with payments if the trade war continues and default on their payments.
“If loan losses occur on a large enough scale, banks could cut back on lending in response, this would exacerbate the economic downturn and put more pressure on businesses and households,” he said.
Bank of Canada Senior Deputy Governor Carolyn Rogers said at the press conference that Canada’s total debt relative to disposable income is “lower than it was a year ago but still high by historical standards.” She said if a “large shock” were to cause job losses, many households would not be able to keep up with debt payments.
Despite the possibility of the trade war disturbing Canada’s economy, Rogers said the country’s banks are “well-positioned” to absorb higher credit losses by saving up more capital and increasing provisions for credit losses.
But Rogers warned that hedge funds have been taking on leverage to buy government bonds. She said that while these purchases have allowed the government to issue more debt without raising borrowing costs, the leveraged purchases pose risks.
“If the trade war causes a larger spike in volatility than we’ve seen so far, leveraged hedge funds might rush to sell their holdings. That could strain liquidity across core markets, increasing stress throughout the financial system,” she said.
Illustrative Scenarios
Macklem and Rogers addressed the Bank’s Monetary Policy Report released in April, which outlined two “illustrative scenarios” on how U.S. trade policies could play out and how that would impact Canada.
“To be clear, our analysis is not a projection. It’s an assessment of vulnerabilities—pockets of existing or potential stress that could spread across the financial system,” Macklem said.
In the first scenario, most of the U.S. tariffs are “negotiated away,” except for 25 percent tariffs on steel and aluminum, and 10 percent tariffs on China. In this scenario, Canada’s GDP would “stall briefly” in the second quarter of 2025 before expanding again, leading to lower inflation in late 2025 and 1.6 percent GDP growth in 2026.
In the second scenario, the U.S. imposes 25 percent tariffs on goods imported from all countries, 12 percent on goods from Canada and Mexico, and 25 percent tariffs on motor vehicles and parts. This leads to Canada’s economy seeing lower exports and productivity, rising unemployment and inflation, and a recession in mid-2025 that lasts for four quarters.
When asked by a reporter if the Bank felt Canada was closer to the first or the second scenario, Macklem said it’s an ever-evolving situation and he hopes the Bank will have a better idea by July. He also said there have been some “positive developments” since April, but it’s still too early to tell.
The U.S. announced a trade deal with the United Kingdom on May 8, which maintains baseline 10 percent tariffs but drops them for automobiles, steel and aluminum. U.S. President Donald Trump also said on May 7 that he could announce “50 to 100 deals right now” with other countries, and on May 9 he suggested tariffs on China could be reduced to 80 percent.
The Bank of Canada’s latest FSR also includes a stress-test scenario by the International Monetary Fund, which projects a recession lasting seven quarters. That scenario also projects that GDP would fall by 5.1 percent and unemployment would hit 9.2 percent.
Macklem said these scenarios imply a “pretty dramatic escalation of the trade war” that will last for a long time. “When you’re doing the FSR you put your gloomy hat on … You think about, ‘okay, what could go wrong?’ And then you ask, ‘How well prepared are we? How do we get better prepared?’” Macklem said.
