Trump's tariff threats - bracing for impact

The Canadian economy, among many others, is emerging from a rather brutal monetary policy tightening cycle (in terms of its speed and intensity) that began in early 2022 and ended in the late Spring of this past year, when the Bank of Canada began to reduce its key policy interest rate (the Bank of Canada rate). The stated reason for this rapid and forceful rise in interest rates was, according to Canada's 2024 Fall Economic Statement "a historic surge in inflation, triggered by Russia's illegal and full-scale invasion of Ukraine and by the economic imbalances and stressed supply chains created by the lockdowns." (Economic and Fiscal Overview | 2024 FES).

The chart below (Figure 1) plots Canada's annual inflation rate and the Bank's overnight target interest rate since 2001. It's clear from the data that the "historic surge in inflation" started in the late Spring-early Summer of 2020, nearly two years before the intensification of the war in Ukraine. Meanwhile, the tightening of monetary policy began in March of 2022, about three months before inflation peaked at 8.10 per cent (at annual rate) in June of 2022.

My point here is not to criticize the Bank of Canada's timing and intensity of monetary policy tightening - first because macroeconomic dynamics are so complex and thus make the exact timing of policy decisions extremely challenging; and second, because I will do that in a forthcoming post. Rather, the reason I point this out is that - because economic dynamics are so complex - the authorities must always exercise extreme caution with monetary policy. This is especially the case for Canada given the importance of interest rates in an economy with comparatively high household debt, exorbitant housing costs, severe housing shortages, and shrinking sources of traditional economic growth.

The second chart (Figure 2, below) plots Canada's gross fixed capital formation, which is private investment in non-residential structures, machinery and equipment, etc. It's worth noting here that private capital formation - which is the organizing principle of a capitalist system - expanded at a robust pace from mid-2020 (peak pandemic) until mid-2023, after18 months of rising interest rates began to hit investment and overall aggregate demand. Consequently, at the end of the third quarter of 2024, capital formation was no higher than in mid-2023. This stagnation of private investment has played a critical role in Canada's negative productivity growth and anemic overall economic growth over the past year-and-a-half.

Again, my intention here is not to criticize, in the first instance. Rather, it's to pose some questions and attempt some answers to them given the looming threats to our international trade coming from President Trump. One question is this: as Canada has just come through a harsh monetary policy tightening cycle with real GDP growth in the 1 per cent range, what policy course will we chart in the event that President Trump makes real his threat of across-the-board tariffs of 25 per cent on U.S. imports from Canada? I refer here not only to trade policy and the possibility of retaliatory tariffs and other measures that have been discussed (e.g., export taxes), but also to monetary policy.

With something like half of our imports comprised of finished consumer goods, and mostly coming directly from the U.S. or indirectly via the U.S., a trade war would operate through three key channels. First, through prices: tariff wars would create a new inflationary dynamic. Second, through the exchnage rate and so-called exchnage rate pass-through to prices and inflation: a trade war would likely deepen the ongoing depreciation of the Canadian dollar, as it would have a much larger negative impact on the Canadian economy and financial markets. Third, through the real sector: across-the-board tariffs and retaliatory measures would impart a significant negative impetus to economic growth. All these factors raise the spectre of stagflation.

With economic growth already so weak, and the potential for a resurgence of inflation through tariffs and currency decline so strong, what is the optimal path for monetary policy? If tariffs and counter-tariffs ignite inflation and hit the real economy (i.e., production), as they almost certainly would, and the Bank of Canada were to raise interest rates to fight inflation, this would further weaken demand and growth - pushing the economy into outright recession. And, if the Bank didn't act to counter the inflationary effects of tariffs and counter-tariffs (and currency depreciation), then we would have inflation along with a still-high risk of recession - or, once again, stagflation.

Such is the unpleasant macroeconomic arithmetic we face in the event that Trump's tariff threats become real. In my view, these two primary scenarios - tightening monetary policy to control the inevitable inflation, or allowing inflation and currency depreciation to accelerate by not raising interest rates sharply, would call for fiscal policy intervention. But is there any scope for fiscal expansion in the current conjuncture? Or, at a minimum, is there any scope for a realignment of existing government expenditures towards so-called growth-friendly spending? This is the subject of a forthcoming post.