By Carl Tannenbaum

A friend of mine was recently complaining to me about his neighbors.  There have apparently been disagreements centered on noise levels, sidewalk snow removal and the alleged leavings of the family dog.  Civil discourse has given way to angry e-mails threatening to seek penalties from the village.

As he described the situation, I realized that I have been blessed in this regard.  We’ve had the same neighbors for decades, and we are very close to them.  That latter spirit has long governed the relationship between Canada and the United States, neighbors in North America who share the longest unfortified border in the world.  But tensions between the two are rising.  The ultimate resolution of the stress will have substantial implications for economic performance in North America, and it will be a harbinger for trade relations elsewhere in the world.

The recent flurry of activity in Washington has been difficult to keep up with. When asked to make sense of it, I counsel care in separating signal from noise.  Threatened extremes often give way to more moderate resolutions; overreacting at an early stage ultimately does little good. But interested parties are preparing for the worst.

For the economies of North America, the worst case is the 25% across-the-board tariffs that the U.S. has proposed for Canadian and Mexican exports, effective February 1.  While economic relations between the U.S. and Mexico have experienced ups and downs, the more neighborly relations between the U.S. and Canada have allowed the development of very deep economic ties. The United States purchases more than two-thirds of Canadian exports; Canada accounts for 17% of total U.S. exports. New tariffs levied by one country against the other would therefore be very impactful.

The two largest categories of Canadian shipments to the U.S. are energy and autos.  Canada produces more than three million barrels of oil each day, almost all of which travels south.  While only about one-quarter of daily U.S. production, it is a substantial amount that would be difficult to replace in the short run.  And while Canada could attempt to sell its crude at more advantageous terms elsewhere, the logistics of doing so would be very challenging.

Trade in autos between the two countries represents deeply intertwined supply chains. Components for some vehicles travel back and forth across North American borders several times, and finished products include important fractions of Canadian and Mexican content.  Tariffs would be very disruptive to assembly logistics, and would be difficult to work around.  Costs for cars would likely rise substantially, and sales would fall.

Given Canada’s greater reliance on exports to the United States, simulations of tariff outcomes find greater impacts for Canada’s economy.  The Bank of Canada estimates that trade conflicts would reduce the rate of growth in gross domestic product (GDP) by about 2.5% in the first year. 

The immediate impact to the U.S. economy would be modest, but retaliatory action would introduce a more significant layer of damage.  Ottawa has promised a “dollar for dollar response,” which might include new levies on agricultural products and curbs on energy exports.  Countermeasures from China and Mexico, the two other main tariff targets, would bring the damage to U.S. real GDP to more than 2% annually.

Continental tariffs would raise prices in all three countries.  Simulations from Oxford Economics suggest that core inflation in the U.S. would rise by 0.5% from its current path. That would be enough to raise the trajectory of interest rates, which would have a dampening effect on growth and market performance.

This week, central banks on both sides of the 49^th parallel met to consider monetary policy.  The Federal Reserve paused, after reducing interest rates by one full percentage point late last year.  During his press conference following the meeting, Fed Chair Jerome Powell declined to speculate on the impact of tariffs, but acknowledged that trade policy was among the factors creating uncertainty around the outlook. 

In Ottawa, by contrast, the Bank of Canada addressed the issue head-on.  After reducing interest rates by a quarter-point, Governor Tiff Macklem cited the prospect of U.S. tariffs as a motivation for the move.  “A long-lasting and broad-based trade conflict would badly hurt economic activity in Canada,” he said.  The bank’s staff produced a piece of extensive research on the topic.

Many suspect that the extremes being kicked around will never be realized.  The expressed reasons for U.S. concern are border security and narcotics, not fair trade.  These issues are much more pronounced along the southern border of the U.S., but Canada has pledged additional investment in border surveillance and interdiction in an effort to avoid trade sanctions. An overly strident posture from the U.S. might lead Canadians to select a hardline prime minister during elections set for the first half of this year, an outcome Washington would like to avoid.

But until matters are settled, businesses are engaged in contingency planning, and investments aimed at deepening North American trade ties have been deferred.  As documented by the International Monetary Fund last year, uncertainty over trade policy is pernicious in itself, even if ultimately resolved.

In 2017, I was heading up to British Columbia to see clients when the first Trump Administration escalated a long-running trade dispute over Canadian lumber, imposing a 24% duty. I received a chilly reception, and was excused only after promising to get the measure reversed.

As luck would have it, I will be traveling to Canada to see clients next week.  If the tariffs go into force on Saturday as promised, I’m expecting at least an hour in the frosted glass inspection room adjacent to customs.  Let’s hope that the longtime neighbors work things out amicably before then.