Cloudy With a Chance of Tariff Relief: Scotiabank’s Forecast Tables

• Though there are clear signs of slowing, recessions are likely to be avoided in Canada and the U.S. unless uncertainty and tariffs rise further.

• In Canada, announced fiscal measures will provide support to growth this year, with the potential for significantly more support pending policy announcements by federal and provincial governments.

• Inflation remains a concern that will limit the Bank of Canada and Federal Reserve’s ability to support the economy in 2025. Inflation control will require much vigilance by central banks.

• We expect both central banks to remain on hold this year and to lower rates in 2026.

Trade and policy uncertainty continue to dominate the outlook despite some backtracking in the tariff war between China and the United States. In the U.S., major uncertainties remain on the way forward on tariffs, which remain at punitively high levels, the future course of fiscal policy, which has been putting upward pressure on longer-term interest rates, and the attractiveness of U.S. dollar assets for investors, leading to a depreciation of the U.S. dollar. These impacts are challenging markets around the world and continue to weigh on economies. The impacts continue to be felt in Canada, though provincial and federal government desires to move at speed on fundamental reform could lead to eventual upward revision to the outlook. While we continue to think a recession will be avoided in Canada and the U.S., this is not a high confidence call. Moreover, inflation risks are expected to dominate over slowing growth for central bankers in Canada and the U.S., suggesting central banks will remain on the sideline this year until there is greater clarity on the relative performance of economies versus inflation, and of course more information on the tariff and fiscal outlooks.

Tariff developments have been mixed since our April forecast update. The U.S. and China agreed to scale back retaliatory tariffs to a less punitive, but still damaging level. A trade “deal” was agreed to with the U.K. These positive developments are set against a doubling of steel and aluminum tariffs which are likely to damage U.S. economic prospects more than they might those of exporting countries. Those positive developments also occur against the background of escalating trade tensions with Europe as President Trump threatened, then delayed, tariffs of 50% of European exports to the U.S. All this to say that trade uncertainty remains elevated, and while we hope for a scaling back of U.S. economic aggression against its trading partners, it is too early to assume this will be the case. As such, we continue to assume announced tariffs will remain broadly in place and that uncertainty will remain elevated. Both are acting to dampen global growth and disrupt supply chains.

We have pushed up our forecast for the U.S. economy owing to the first quarter being less weak than we had expected and the reduction in tariffs. While indicators point to softness that continues in the second quarter, trade data have been distorted by the anticipation and implementation of tariffs. We believe, as a result, that imports will contract significantly in the second quarter, thereby putting upward pressure on growth. A recession is likely to be avoided, but that depends on the evolution of trade policy. Further aggravation on that front can easily cause a more meaningful slowdown than currently expected. For the moment, we forecast growth of 1.5% this year followed by growth of 0.9%. Growth at those levels would be well below potential growth and open spare capacity sometime in 2026. That spare capacity should put downward pressure on inflation from the elevated levels observed at present. In time, this will allow the Federal Reserve to lower its policy rate. We do not think this likely before 2026, but there is a risk of an earlier cut.

There remains significant uncertainty as to how the tariff shock is working its way through the economy. The import and inventory surge in Q1 will be unwound in coming months or quarters. That is near certain. Beyond that, it is unclear how the inflationary process will be impacted. Publicly listed firms are suggesting they will raise prices in response to tariffs, while survey measures of inflation expectations remain very high. This suggests the risk to inflation remains substantial, hence our view that the Fed will remain on hold in the next few meetings.

The relative loss of investor appetite for U.S. assets is increasingly becoming a forecasting issue. Concerns about U.S. fiscal plan(s) have led to a rise in U.S. borrowing costs that have spread to other markets. Investors questioning U.S. exceptionalism, which has seen U.S. equity markets outperform advanced economy markets for years, are leading some asset managers to reduce allocations to the U.S. Both these factors, along with a general malaise about the direction of U.S. policy has contributed to exceptional moves in currency markets, where the U.S. dollar has been depreciating even as tariffs hit (which should cause the dollar to appreciate), and relative borrowing costs rise. As a result of this, we now expect the U.S. dollar to continue to depreciate on an effective basis through 2026. One consequence of this view is that we now foresee a significant appreciation of the Canadian dollar going forward, with the USDCAD hitting 1.34 as 2025 progresses.

Our forecast for Canada remains roughly in line with our earlier expectations for 2025 at about 1.4% but higher in 2026 at about 1.1%. Growth in the first quarter was stronger than expected owing largely to a surge in exports that incoming trade suggests is already being unwound. It is clear the economy is slowing, and we now expect a decline of almost 1% on a quarterly basis in the second quarter. That reflects the export reversal, but also sluggishness in the housing market and manufacturing sector. This sluggishness continues to reflect the impacts of tariffs and associated uncertainty. We do not expect a recession despite the expected performance in Q2. The federal personal income tax cut comes into effect July 1^st. The government has already eliminated the GST on new homes under $1 million for first-time homebuyers. The Ontario government has effectively launched a mini-support program for its economy. More recently, PM Carney has committed to increasing our defence spending to 2% of GDP this fiscal year, years ahead of plan. It is clear that much is happening in the policy space at the federal and provincial levels that have the potential to raise growth (and debt) going forward. We will wait until concrete measures are announced and implemented. For the time being, we continue to believe fiscal policy represents a clear, and potentially significant, upside risk to our forecasts for growth, inflation, and interest rates.

Though growth is forecast to remain below potential through 2026, implying a widening output gap, inflationary dynamics remain troublesome. Our model uses the average of the Bank of Canada’s two core inflation measures. Those are tracking around 3% on a y/y basis in Q2, about 0.25 percentage points higher than in our earlier forecast. It is unlikely that the acceleration of core inflation so far in the quarter reflects the direct impacts of tariffs and our retaliation. This makes the sharp rise in core inflation observed so far more problematic. Inflation expectations are high for the next twelve months. Wage growth exceeds productivity, and we know that supply constraints pose additional risks to inflation. We now expect a moderation of core inflation of 2.6% by the end of 2025 and 2.2% by the end of 2026 as excess supply exerts downward pressure on inflation, but it would be foolish to believe the risks to inflation are not tilted to the upside given recent developments in inflation itself, and the risk that fiscal policy would push growth above our forecast.

As so clearly indicated by Governor Macklem, the Bank of Canada’s challenge in setting policy is to consider which is of greater concern for inflation dynamics: the rise in inflation that we have seen and may see more of versus the slowdown in growth. At present, the further deviation of inflation from its 2% target is winning that horse race. As a result, we do not believe the Bank of Canada will cut its policy rate this year. We hope to be surprised with lower inflation, allowing for some monetary easing, but that simply cannot be counted on at this point. The Bank of Canada, as we all are, remains in extreme data dependency mode. It is more likely that the policy rate will be cut in 2026 as we enter the second year of below-potential growth, and we indeed forecast 50 basis points of cuts in 2026. Again, however, that outcome will depend critically on the evolution of the trade war, how households and businesses have responded, and the policy supports deployed by federal and provincial governments.

From a provincial perspective, we expect Ontario and Quebec to underperform the national average due to their larger exposures to tariffed sectors. In the first three months of the tariff war, the Ontario economy lost nearly 60,000 jobs and the unemployment rate has risen to nearly 8%, though employment in Quebec has been more resilient. Home sales have also been quite weak since February in Ontario (down roughly 25% y/y), as households delay major purchases due to the uncertainty created by the trade war—and perhaps to some extent to await the GST relief on new homes for first-time home buyers that took effect in late May. In contrast, economic activity has remained robust in the oil-exporting provinces, and we expect them to overperform the national average in both 2025 and 2026. However, new tariffs and other potential external shocks could affect this outlook, and the elevated uncertainty is likely to continue to weigh on all regions of the country.