Donald Trump’s trade war — unleashed in his first administration but renewed with enhanced fury at the outset of his second administration — threatens the rules-based international trading system built in the wake of the Second World War. That system was instrumental in unwinding the beggar-thy-neighbour trade, financial and economic policies responsible for the economic carnage of the 1930s — particularly short-sighted tariff policies, especially the disastrous Smoot-Hawley tariff legislation in the United States. Smoot-Hawley will forever live in infamy in the annals of economic policy making.
Trump’s use of section 338 of that bill against Canada in the most recent skirmish in his trade war is perhaps the clearest indication of his intention to disrupt international economic and geopolitical relations. It also raises fresh concerns about the consequences of the uncertainty generated by the disruptive trade and tariff policies of his administration.
Three considerations warrant careful assessment to gauge the impact of this latest trade shock and how best to respond to new tariffs in the long term. The first of these considerations is the current macroeconomic conjuncture, or the prevailing state of the economy. There is a critical difference in this regard between the first round of Trump tariffs, now almost a decade ago, and the latest salvo against the international trading system.
At the time of the first Trump administration, the United States was still recovering from the so-called “Great Recession” following the global financial crisis; output remained below potential and unemployment remained above its natural rate. Given this slack in the economy, inflation was quiescent and, perhaps more importantly, long-term inflation expectations were firmly anchored on the US Federal Reserve’s (the Fed’s) implicit two-percent inflation target. Those factors, combined with expansionary tax cuts, masked the negative effects of tariffs; indeed, however damaging these tariffs were from a long-term perspective, they likely accelerated the return to full employment by switching demand from foreign to domestic goods.
None of these conditions hold today. In contrast to the macroeconomic conjuncture a decade ago, actual output currently exceeds potential, while unemployment is broadly at its natural rate. Inflation — which had spiked in the pandemic but was steadily converging on the Fed’s inflation target prior to Trump’s re-election — remained stubbornly above that target through 2025 as the tariff war resumed. More recently, inflation has jumped significantly in the wake of the US war with Iran, which has led to significantly higher oil prices. Inflation expectations, meanwhile, have risen since the start of hostilities at the end of February.
As a result, whereas US monetary policy could remain accommodative in the face of tariff-related price shocks in the first Trump administration, the Fed no longer has that flexibility. In fact, the risk now is of the US central bank losing its credibility if it fails to respond to rising inflationary pressures generated by new tariffs. (The Bank of Canada has more room for manoeuvre given the potential adverse shock to the Canadian economy that Trump’s latest tariffs represent.) Bond markets have already priced in higher interest rates, with long-term bond yields increasing in recent weeks in part because of rising inflation expectations and the massive increase in debt issuance associated with AI “hyper scalers.” These higher interest rates and a worsening macroeconomic conjuncture could erode the already weak public support for the administration’s policy agenda.
The Case for Targeted Support
The expected duration of the trade shock is the second key macroeconomic consideration. A cardinal rule of macroeconomics is “finance temporary shocks, adjust to permanent shocks.” This policy prescription reflects the proposition that optimal long-term investment plans should not be abandoned in response to transitory shocks. Rather than write off long-term investments in plant, equipment and human capital, it is more efficient to finance temporary losses that may result from temporary tariff shocks. However, adjustment is the appropriate response to permanent shocks; failure to adjust fundamental saving and investment decisions in such circumstances — to recognize that those decisions are no longer optimal — could entail underwriting losses arising from the inefficient allocation of resources (capital and labour) over time. Such a response is a recipe for the steady, sustained decline in economic prosperity.
But even if the Trump administration succeeds in permanently rewiring North American trading relationships, the macroeconomic impact of this seemingly permanent shock could be rendered temporary if Canada develops new trading relationships in Europe and Asia as is the government’s strategy. In this context, the development of large infrastructure projects using Canadian inputs of steel and other products subject to US tariffs would avoid the premature depreciation of physical and human capital and bridge between trade regimes.
The third key factor to consider in evaluating the impact of the latest round in the trade war is the appropriate macroeconomic policy response. The emphasis here should be on targeted policy responses designed to support workers and sectors adversely affected by the Trump tariffs and to facilitate the adjustment process; not broadly-based tax cuts to boost aggregate demand. In the first instance, recent data reveals that domestic demand is holding up well in Canada, despite the uncertainty induced by the Trump administration. The government is already providing considerable fiscal stimulus with infrastructure projects and by strengthening the military. Adding further stimulus through tax cuts would boost demand pressures in the economy and could merely fuel inflationary pressures, limiting the Bank of Canada’s flexibility to respond to changes in the economic conjuncture.
Moreover, although Canada has an enviable fiscal position, with the lowest net general government debt burden in the Group of Seven (G7), in an uncertain world and with rising global bond yields prudence is called for. Any use of fiscal space should be carefully assessed. In this respect, tax cuts may not be an effective instrument given the uncertainty generated by Trump’s trade policy. This is because tax cuts would likely be saved while uncertainty suppresses private investment. More fundamentally, tax cuts would be of little value to workers who have lost their jobs (and incomes) because of US tariffs and who need retraining and assistance in making the transition to new employment.
The latest flare-up in the ongoing trade war with the United States will undoubtedly impose costs on both sides of the conflict. Canada is well positioned to absorb these costs. It has the lowest net debt burden in the G7; the credibility of the Bank of Canada’s commitment to maintain low, stable inflation remains intact, while government spending on infrastructure and targeted assistance will cushion the impact of tariffs on vulnerable workers and sectors. In contrast, the US fiscal position continues to deteriorate, despite robust growth, drawing the attention of financial markets and pushing bond yields higher.
Inflation has risen and further price pressures can be expected from the latest tranche of Trump tariffs and higher oil prices. The United States also has a central bank at risk of losing its credibility if it fails to raise interest rates in the face of rising inflation. In this respect, these macroeconomic considerations could well determine how the current impasse in trade negotiations between Ottawa and Washington is resolved and whether this trade shock is a bump or a turning point.
