The U.S. threats to impose punishing tariffs on its largest trading partners—Canada, Mexico, and China—and the determination of these countries to reciprocate have raised alarm bells over the potential for rising inflation.

If inflation does increase, it will not be pretty. Tariffs represent what economists call a supply-side shock, and the resulting higher inflation is likely to be accompanied by a slowdown in economic activity. This combination of inflation and stagnation, known as stagflation, poses significant challenges for monetary policy. If the central bank focuses on controlling inflation and raises its policy interest rate, it risks further slowing economic growth. Conversely, if it tries to stimulate the economy by lowering interest rates, it risks exacerbating inflation. Additionally, higher inflation coupled with rising unemployment leads to job losses and an increased cost of living—outcomes that every economy strives to avoid. But how serious is the threat of inflation due to the impending trade war?

Is a Trade War Inevitable?

First, it is possible that the trade war may not materialize. President Trump may be using these threats as bargaining chips to extract concessions from trading partners. There is some evidence to support this view. According to The Economist magazine:

“In his first term, Mr. Trump repeatedly backed out of tariff threats: America’s effective average tariff rate rose by just 1.5 percentage points. Ever the showman, he delights his base by throwing America’s weight around and boasting of his victories.”

This time, he delayed the tariffs on Canada and Mexico by 30 days—just one day before they were set to take effect.

The Inflation Impact: U.S. vs. Canada

Second, the inflationary impact will depend on how open an economy is and how reliant it is on trade with the affected partner. In the fourth quarter of 2024, the share of imports in the U.S. GDP was just 14%, compared to 32.7% for Canada in the third quarter of 2024. Moreover, Canada is far more dependent on U.S. imports than the U.S. is on Canadian goods. Canada’s imports from the U.S. account for over 20% of Canada’s GDP, while U.S. imports from Canada represent just 2% of U.S. GDP. Hence, if both countries impose similar tariffs on each other’s products, Canada will experience a much greater price shock than the U.S.

Although consumer inflation expectations in the U.S. rose from 3.3% in January to 4.3% in February, the expected inflation rate—as measured by the yield spread between 10-year Treasury bonds with and without inflation protection—was 2.42% on February 5, 2025. This is only slightly higher than 2.27%, its level on Election Day. These figures suggest that while Trump’s threats and shifting positions have created uncertainty among ordinary Americans, financial markets remain confident that the overall effect on U.S. inflation will be limited. It is unclear whether markets expect no trade war or anticipate minimal inflationary effects even if tariffs are imposed.

What Does This Mean for Canada?

If there is no trade war, Canada has little to worry about. However, if tariffs are imposed for an extended period, Canadian inflation will likely rise. The exact magnitude will depend on the size and duration of the tariffs.

If this high-inflation scenario unfolds, policymakers will face tough choices. If the federal government responds with increased spending to ease the burden on Canadians—and if the central bank accommodates this expansionary fiscal policy by lowering interest rates—inflation could worsen in the short run.

The best-case scenario for Canada is clear: the tariff threats do not materialize. 

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