Canada’s economy is set to weaken amid ongoing trade wars even though the U.S. has stepped back from broad reciprocal tariffs and applied only targeted tariffs on Canada.

U.S. tariffs on China and other trading partners, along with growing uncertainty, is likely to slow U.S. growth meaningfully and weigh on Canadian growth. Lower oil prices won’t help as well.

Our current base case forecast does not imply a technical recession, but the Canadian economy has already been operating below capacity, posting weak growth for the past two years. While current tariff policy and the inflation backdrop will make the Bank of Canada’s job harder, our view has been that it could cut interest rates further.

But as ongoing trade frictions threaten Canadian growth in 2025, and the potential for much larger trade shocks loom ahead, monetary policy isn’t likely to be the first line of defence in buffering the economy. Fiscal policy will be key as it is better able to provide timely, targeted, and temporary support.

Even before trade tensions began, public debt levels were likely to face burdens—spending pressures ran the gamut from housing, ageing to the upcoming federal election. Now, with a global reordering of trade in play, it’s worth asking whether federal finances can withstand a major trade war and its fallout.

As a first step in what will likely to be an ongoing discussion in this year, here’s what federal finances could be facing and what it means for Canada’s fiscal health.

Federal debt burden was set to move sideways even before new spending

Last year’s economic growth come in stronger than assumed in the federal fall update, but the positive news ended there. Based on our most recent April forecast, growth will be somewhat weaker ahead, especially in 2026.

Updating the federal deficit and debt track in the fall update with this new economic forecast (and no other information) indicates that the slowly declining federal debt ratio planned in the fall is headed mostly sideways as a starting point.

Campaign promises imply fiscal policy could be moderately (further) expansionary but a major tariff shock would require larger support

No party has released a costed platform ahead of the April 28 federal election yet showing the spending profile of campaign promises, but announcements suggest some of it could be allocated over the next two years, especially billions in personal income tax cuts.

A ramping up of defence spending toward NATO’s 2% target is likely also in play. Federal and provincial governments have announced several business liquidity and worker support programs in response to trade stress. These are relatively limited to date, but could add incrementally to the fiscal impulse.

The fiscal lift may be supportive of the current conditions, but it would be much higher in a larger trade shock. The impact of a tariff shock on the Canadian economy depends on the specifics, but for illustration, we’ve modelled one severe and unlikely scenario of a three-year blanket 25% U.S. tariff on Canada, which would produce a two-year recession before any fiscal or monetary support.

To plug the economic gap, a net fiscal response of about $145 billion could be needed over the next two years, net of some revenue from retaliatory tariffs, or 4.7% of gross domestic product (assuming tariffs are in place starting the second quarter of 2025). Should the federal government take it all on, its net debt ratio would peak at 46%, in line with the recent COVID-19 high. The peak would be about 45% with a federal share closer to the 80% pandemic split.

Support through a recession is expected, unlikely to raise red flags if sized and targeted appropriately

As debt buyers, investors are the ultimate arbiters of fiscal sustainability, and government debt markets are generally the most efficient in the world. They also prey on the weakest.

Despite the increase, Canada’s debt ratios would remain relatively favourable and it likely gives the government more fiscal room compared to an “absolute” view of debt that has worsened. Canada’s consolidated government gross debt is high relative to other AAA-rated peers, but its net debt is much lower and the lowest in the G7.

Fiscal firepower is meant to be released during recessions or structural crises to cushion the economy and help it adjust. A permanent tariff shock would be both. Notably, now that the trade war has shifted from a North America focus, economies from Europe to Asia are also likely to be leveraging fiscal policy to support slowdowns in growth. Put differently, Canada would be fiscally supporting its economy in parallel with others.

Provided governments target and size fiscal support reasonably, market and credit rating agency actions should be limited. Lessons from the COVID-19 fiscal response showed how disproportionate and extended support programs fuelled fraud and stoked inflation.

Furthermore, we have written that COVID-19 is not the right playbook for a trade shock since the economy could look structurally different on the other side of the event. Instead of pandemic-era measures, we’d expect the more fiscal packages focus on structural adjustments, the more favourably they would be received.

Prepare for more major spending ahead

Supporting the economy through a potential trade-related recession won’t be the end of fiscal asks ahead even as all eyes are on the trade wars and an immediate response from governments.

Besides a gameplan to diversify export markets and lift business investment, housing, ageing, climate, defence, and the cost of trade peace with the U.S. are all expected to lift structural spending. That’s true for Canada as well as several developed economies facing similar issues.

If public debt levels are set to trend upwards for an extended period, governments are going to have to try to ensure that new spending delivers the growth dividends necessary to keep elevated debt levels sustainable. It’s a tricky balance, and one we will be exploring through our research in 2025.

Cynthia Leach is Assistant Chief Economist at RBC covering the team’s structural economic and policy analysis. She joined in 2020.

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