Growth not as grim as expected, for now

Economic growth for Canada and the U.S. is tracking slightly better than expected, according to a new report from Scotiabank economists that revised their forecasts modestly higher.

While growth will still be weak — and below potential — in both economies due to U.S. trade policy, the report said data suggests both markets are holding up better than first feared.

“Growth in Canada appears to be on a better track than we had assumed in our last forecast,” it said. “This is not to say the economy is strong. It remains weak across a broad range of indicators, but on balance the economy is less weak than we had earlier assumed.”

For instance, while the bank expected real GDP to decline by about 1% in the second quarter, it now appears growth will come in slightly positive.

The labour market is holding up better than expected, and there are signs of recovery in the housing market, it said.

“Moreover, informal conversations with clients suggest a more optimistic view of the outlook relative to the last few months,” the report said.

Of course, ever-shifting U.S. trade policy continues to loom over the economic outlook — and Scotia’s forecasts don’t incorporate the latest tariff threats.

“We will wait until policies actually take effect before reflecting those in our forecasts. There is simply too much uncertainty about the way forward on trade to build those into our forecasts at the moment,” it cautioned.

That said, it also noted the latest threats “seem like they would result in stronger downward revisions to growth and higher revisions to inflation in the U.S. relative to its trading partners.”

While the latest U.S. forecast doesn’t attempt to factor in new trade policy promises, it does incorporate the impact of the just-passed U.S. budget bill.

“This results in a more stimulative fiscal policy at the margin, as our forecasts had never incorporated the phasing-out of the tax cuts implemented in the first Trump mandate,” it said.

Against that backdrop, Scotia revised its U.S. growth forecasts up modestly for this year and next, and now expects GDP of about 1.5% in both 2025 and 2026.

“The outlook continues to reflect the negative impacts of tariffs and policy uncertainty, which, as noted above, could lead to downward revisions to growth once there is more clarity about the policy environment,” it said.

Additionally, there are upside risks to inflation as a result of higher tariffs, it noted. “We are starting to see signs of this in inflation data, and these effects will be even more apparent in coming months,” it said.

The prospect of higher inflation is likely to keep both the U.S. Federal Reserve and the Bank of Canada from cutting interest rates for the rest of this year, the report noted.

However, financial markets are also subject to heightened uncertainty — not only from the passage of the U.S. budget bill, which “adds significantly to fiscal sustainability concerns” — but also from the “increasingly shrill calls for the removal of Federal Reserve Chair Powell.”

If the Fed chair were removed prematurely, U.S. benchmark interest rates would likely be cut. But such a destabilizing move would sharply curtail demand for U.S. assets, “leading to higher longer-term yield spreads, a lower dollar, and potentially lower equity valuations,” the report said.