By Douglas Porter

August 1, 2025

Just as financial markets were preparing to put the trade war into the rear-view mirror after August 1, we were served a late-week double-barrelled reminder that its economic impact has a long tail. First, the core PCE deflator rose a rather meaty 0.3% m/m in June, fired up by a big and rare 0.5% rise in durable goods prices. This lifted the Fed’s main inflation gauge to 2.8% y/y, a tick higher than even the Chair expected. Next, July payrolls were soggy at just +73,000, replete with heavy downward revisions to prior months. This left the average private sector payroll gain at a mere 84,000 so far this year, the slowest pace since 2010 (aside from distorted 2020). One could readily make the case that some of the cooldown in hiring is a supply-side issue, as the labour force has, on net, dropped over the past six months (Chart 1). Nevertheless, the all-important jobless rate ticked up to 4.2% (and just shy of 4.3%), and the factory ISM chimed in with a disappointing 48.0 for July. The somewhat high-side inflation result and decidedly squishy jobs report had a distinct whiff of stagflation-lite about it.

The slightly sour economic readings crashed what had been a rollicking equity market party. Following an almost unbroken string of weekly gains, the S&P 500 had bounced more than 28% from its April low by the time it reached a new record high on Monday. But it was tough sledding through the rest of the week, with even tech stocks retreating from early-week highs, despite well-received earnings reports from Microsoft and Meta. Bonds focused much more on the soft aspects of the economic reports, with 10-year Treasuries sliding 15 bps on the week to below 4.25%. In turn, the nascent recovery in the U.S. dollar was cut short, albeit it was still up on the week; it rose almost 2% against the euro on net.

The sluggish jobs report quickly changed the conversation around the Fed outlook. Following Wednesday’s as-expected FOMC decision to hold rates steady yet again, and Chair Powell’s non-commitment to rate cuts, as well as the surprisingly perky 3.0% Q2 GDP result, the market had begun to price out odds of even a September trim. And, there were many suggesting there would be no cuts at all in 2025—especially after the uptick in June inflation. That abruptly changed after payrolls; with no prompting from Pennsylvania Ave, markets are now almost fully expecting a September cut, and a follow-up move before year-end, exactly matching our current expectation.

While the seemingly never-ending trade drama will weigh more heavily into the economic data in coming months, at least we all have a bit more clarity on that file after the flurry of announcements this week. The European Union kicked off the festivities with a 15% handshake deal with the U.S. Administration, setting the tone for others—and Korea soon followed. Heavyweights China and Mexico were set to the side, with the former still negotiating to its August 12 deadline and the latter kept at its 25% rate for three months on non-USMCA goods. Canada was not spared with a three-month reprieve; instead, it was stuck with a 35% levy on non-compliant goods (which may well represent less than 10% of all exports to the U.S.). Many others were just unceremoniously given a number, including a staggering 39% on Switzerland, 25% on India and 50% on some products from Brazil. Overall, we estimate that the combined net U.S. tariff on imported goods will land near 19%, up from little more than 2% at the start of the year. There are many ways to analyze this, but distilling it down:

U.S. goods imports were US$3.47 trln in the past 12 months

U.S. nominal GDP is now $30.33 trln annualized

Imports are thus 11.44% of GDP

A 17 ppt hike in tariffs implies an extra cost of $590 bln, assuming no big shift away in imports, or 1.94% of GDP

Someone, somewhere has to bear that cost of 1.94% of U.S. GDP

Given that the U.S. is going it alone in hiking tariffs on the rest of the world, with almost no response from others, the natural market reaction should be to drive the U.S. dollar higher. This trend could be reinforced by a curious sidebar feature in many of the frameworks with important trading partners. Besides accepting unilateral tariffs on their goods, each of Japan ($550 billion), Europe ($600 billion) and South Korea ($350 billion) made lavish pledges to ramp up direct investments in the U.S. economy. We will see to what extent these public pledges are actually carried through, but, in theory, a massive inflow of FDI would also tend to drive the dollar higher. We’re also left wondering how the U.S. balance of payments will, in fact, balance when both the trade and investment accounts are moving in the same direction. One potential answer is for foreign investors to sell down their U.S. portfolio holdings—i.e., stocks and bonds—probably not the result the Administration was looking for.

While the inability of Canada to reach a deal with the U.S. and avert the back-up in its “fentanyl” rate to 35% is a disappointment, the Canadian dollar took it in stride. First, the probability of no deal by August 1 had been well-telegraphed, and accounted for some of the loonie’s net loss this week. Second, the reality is that the 35% rate affects only a small share of Canada’s exports, and bumps up the effective average tariff rate by less than a percentage point (to perhaps 7%). Our concern is that the stalemate does not reflect well on the prospects for a renegotiation of the USMCA over the next year. And, it’s rather clear that the threat of a 35% fallback tariff rate will loom over the proceedings, potentially acting as a cudgel.

The Bank of Canada is well prepared for all eventualities, as this week’s rate decision and Monetary Policy Report came with three scenarios, including one with an escalation in tariffs. But even in that darker outlook, the Bank only looks for GDP to pull back an additional 1.25%—serious for sure, but far from disastrous. The Bank is less concerned about the downside risks to the economy, while also remaining keenly focused on upside risks to inflation. As a result, there was a strong consensus among policymakers to keep rates steady this week for the third consecutive meeting. And while the Bank gamely kept the door ajar to future cuts, the market is now priced for less than one full trim through the rest of 2025. Our call remains somewhat more dovish, especially with the U.S. economy cooling a bit more noticeably.

A relatively calm Canadian GDP result did not boost rate cut prospects. While output did indeed drift lower in both April and May, through the heart of the trade turbulence, it now looks like GDP edged back up in June. For all of Q2, output was about flat, a much more benign outcome than expected at the start of the quarter. However, we and the BoC suspect that when the full evidence is in at the end of this month, it will show a moderate contraction in the quarter (we are at -0.8% a.r.). Even so, the steady end to the quarter and the fact that most Canadian exports are still duty-free has prompted us to nudge up our call on Q3 growth. We now suspect the economy will manage to eke out some growth this quarter, boosted by the personal tax cut at the start of July, by robust domestic travel, and by the less-dire sentiment around the outlook. It’s not a big change in our view, but symbolically we have now scrubbed the “technical” recession from our call by lifting Q3 into positive terrain.

Policy Contributing Writer Douglas Porter is Chief Economist for BMO.