Canada’s economy is headed for a contraction — the first since the COVID-19 crisis — if a tariff war with its largest trading partner lasts for long.

Economists have estimated that U.S. President Donald Trump’s tariffs on Canada will shave two to four percentage points off the country’s gross domestic product growth. The administration imposed levies of 10 per cent on Canadian energy and 25 per cent on all other goods, starting Tuesday.

That prompted Canada to retaliate with tariffs on an initial $30 billion of American goods, which will expand to $155 billion in three weeks. Assuming the tariffs stay in place, the actions will spur an economic slowdown and drive prices higher, economists say.

“A couple of quarterly contractions are likely for Canada, i.e., a moderate recession, before growth gradually resumes,” Sal Guatieri and Shelly Kaushik, economists at the Bank of Montreal, wrote in a report to investors. “Counter-tariffs and a weaker currency could see inflation spike more in Canada.”

Traders priced in a 95 per cent chance the Bank of Canada will cut its policy interest rate next week.

The combination of rising price pressures and a slowing economy — one definition of stagflation — puts the central bank in a bind. While the economic shock is likely to compel it to cut borrowing costs, officials must also be mindful of stoking inflationary pressures.

Governor Tiff Macklem said in a speech last month that a prolonged U.S.-Canada tariff war would hit Canadian output by nearly three per cent over two years and “wipe out growth” during that period.

But in their trade battle scenario, Macklem said the factors pushing prices higher “more than offset the downward price pressure from weaker demand,” causing inflation to rise above the two per cent target.

“We can’t let a tariff problem become an inflation problem,” Macklem said.

The impact in Canada will depend on how long the tariffs remain in place. There is significant uncertainty about Trump’s resolve, given that he’s previously backed down on tariffs — allowing Canada and Mexico a one-month reprieve in early February.

Investors don’t know duration “and that’s key,” Derek Holt, economist at Bank of Nova Scotia, said in a report. “Trump is a showboater and self-promoter with zero scruples and so for all we know he put these tariffs on just in order to be able to point to them in his speech tonight but they may not last.”

“The Bank of Canada is likely to cut next week as tariffs tip the balance in that direction, but expect a very measured bias given the potential effect of tariffs on supply chains and inflation.”

Even before the tariffs hit, Trump’s threats alone were throttling business investment and consumer confidence.

Some economists see Canada’s retaliatory tariffs as making a bad situation worse, adding to growth woes and increasing price pain for Canadians while doing little to dissuade the U.S.

“Canada’s retaliatory moves are economically counterproductive and limit monetary policy response, which hurts Canadian consumers, producers, and government finances,” Bryan Yu, chief economist at Central 1 Credit Union, wrote in a report to investors.

Canada’s economy was recovering sharply at the end of 2024, rising at a 2.6 per cent annualized pace in the fourth quarter. That was driven by the central bank’s aggressive interest rate reductions, which boosted domestic demand, including household consumption and housing activity.

Bloomberg.com