Key themes for 2025

We use the final #MacroMemo of the year to preview 11 key macroeconomic themes for 2025.

1 - Sustained economic growth

We anticipate further sustained economic growth across the developed world in 2025. This is hardly revolutionary in that growth is the default state for economies. But this is nevertheless worth conveying, for two reasons:

• After years of elevated recession fears, a prediction of growth is notable.

• This expectation of economic growth serves as the necessary bedrock upon which several of the other themes are based.

Supporting this growth outlook, economic headwinds have faded. Central banks have cut rates, several recession signals have ceased to blink red and economic growth has stubbornly persisted in recent quarters despite considerable adversity.

U.S.-specific growth has been especially buoyant recently, with the Beige Book tilting higher again (see next chart). In our view, the country’s housing market is set to make moderate gains as interest rates fall. Consumers should enjoy some upside for the same reason. There is also space for further growth in capital expenditures, motivated by the AI boom and declining rates. Conversely, international trade may provide less economic support as tariffs potentially revive.

Beige Book Sentiment Indicator rising

As of November 2024. The indicator quantifies the sentiment of local contacts by assigning different weights to a spectrum of positive and negative words used to describe overall economic conditions in the Fed Beige Book. Sources: U.S. Federal Reserve, RBC GAM

While the U.S. faces the distinct risk of overheating – more on that in the “no landing” scenario theme – it remains reasonable to expect moderate growth. This would be consistent with an unemployment rate that has increased off its lows since last summer but is now proceeding roughly sideways (see next chart). The recent payrolls print of +227,000 for November overstates the heat of the labour market given that it also represented a catch-up month after hurricane distortions in October. The underlying trend remains moderate – neither too strong nor too weak.

U.S. unemployment rates have risen, but tentatively stabilizing

As of November 2024. Sources: U.S. Bureau of Labor Statistics, Macrobond, RBC GAM

The rest of the world has failed to advance at quite the same pace as the U.S. over the last few years. These other countries lack the tailwind of the AI boom, and high interest rates have hurt. But growth expectations for 2025 remain reasonable in these other markets, and we even expect a moderate acceleration from 2024. Central to this, rate cuts are proceeding with greater vigour in non-U.S. markets, and these should prove especially effective at unlocking economic growth given a higher level of rate sensitivity than in the U.S. 

2 – Vibecession to fade

Although a recession was avoided in recent years, unemployment rates have been low and inflation is now substantially tamed, a so-called “vibecession” has weighed on households and businesses. This is to say, people felt that the economy was awful even if it technically wasn’t. This may have been a factor in the dissatisfaction expressed in the recent U.S. election.

It is worth turning to the Misery Index for an objective snapshot of the economy. This is a simple but hallowed measure that simply adds a country’s unemployment rate to its annual inflation rate. A higher number is more miserable, a lower number is less miserable. Happily, the great majority of developed nations examined report an unusually low misery index (see next chart).

Misery Index shows most developed nations doing better

Updated 12/11/2024. Misery Index is calculated as a country’s year-over-year inflation rate plus the unemployment rate. Sources: U.S. Bureau of Labor Statistics (BLS), Statistics Canada, UK Office for National Statistics (ONS), German Federal Employment Agency (Bundesagentur fuer Arbeit), French National Institute of Statistics & Economic Studies (INSEE), Italian National Institute of Statistics (IStat), Spanish National Statistics Institute (INE), Japanese Statistics Bureau, Ministry of Internal Affairs & Communications, Central Bank of Germany (Deutsche Bundesbank), Macrobond, RBC GAM

Other than Japan, which is not accustomed to even moderately positive inflation readings, the Misery Index is uniformly below the 50^th percentile for each examined country. This is to say that each country’s Misery Index is currently better than it has been over more than half of its history. Specifically, the current U.S. misery index is in just the 33^rd percentile, Germany (despite a lack of recent economic growth) is just the 28^th percentile, and the U.K. and Canada are both in just the 26^th percentile.

Meanwhile, Spain, France and Italy are somewhat remarkably in the 5^th, 1^st and 0^th percentile, accordingly! This is to say that the Italian Misery Index is at its lowest since the underlying data became available starting in the early 1980s (see next chart).

Italian Misery Index reaches new low

As of October 2024. Sources: Italian National Institute of Statistics (Istat), Macrobond, RBC GAM

How to reconcile the vibecession with a low Misery Index? One thought is that it appears that political partisanship has begun to colour survey respondents’ views about the state of the economy, most notably in the United States. Republicans think the economy is bad when a Democrat is in power, and vice-versa. When a transfer of power occurs, one group’s assessment skyrockets while the other’s plummets. So a part of the pessimism about the economy may be partisan rather than entirely objective.

More sympathetically, interest rates are burdensome, housing is expensive and prices remain much higher than they were before the pandemic, even though the rate of inflation has since slowed. There is genuine pain here, even if it doesn’t fit into the standard rubric of metrics like GDP (gross domestic product), inflation and the unemployment rate. The higher price level shouldn’t be such a big problem given that wages have finally caught up to the higher prices, but of course not everyone participated equally in the higher wages. And housing affordability is undeniably poor.

Another idea is that modern society and social media manage to circulate a lot of negative feelings. It is easier to be aware of the world’s problems today, to be alerted to transgressions at the scale of the individual, and to air grievances. At the same time, it is easy to forget about the world’s problems from yesteryear. This potent cocktail results in many opining that the latest year is always the worst ever.

More sympathetically, interest rates are burdensome, housing is expensive and prices remain much higher than they were before the pandemic, even though the rate of inflation has since slowed. There is genuine pain here, even if it doesn’t fit into the standard rubric of metrics like GDP (gross domestic product), inflation and the unemployment rate.

As a fun test for the idea that we forget that the world has always had problems,  we had a random number generator pick a random year between the end of World War II and the global pandemic. It chose the year 1978. Let us detail the many problems that existed in 1978, many of which we forget about – with the implication that things aren’t necessarily all bad today. When not otherwise indicated, the data is for the U.S.:

• Yes, inflation is too high today, at around 3%. But it averaged a big 7.6% in 1978.

• Yes, short-term rates today are higher than would be optimal at 4.75%. But the fed funds rate rose to 10% in 1978.

• The 1978 unemployment rate was 6.1%, versus just 4.2% today.

• The level of inflation-adjusted wages was 15% lower in 1978 than today.

• The S&P 500 managed to eke out a 1.1% gain in 1978, but this was a far cry from the +28% year-to-date in 2024.

• While there are serious geopolitical problems in the world today, the Cold War was well underway in 1978 with virtually the entirety of Eastern Europe occupied or otherwise controlled by the Soviet Union. The Iranian revolution had begun, with implications for the price of oil. There was war between Cambodia and Vietnam (the Pol Pot genocide was also ongoing in Cambodia), another war between Uganda and Tanzania, and rebels invaded Zaire (with France and Belgium responding). Ethiopia and Lebanon both had civil wars, and the South African border war was underway. A major Ethiopian famine was also underway.

• From a crime perspective, the U.S. homicide rate was approximately 50% higher in 1978 than today, with a number of prominent serial killers active and the Son of Sam trials ongoing. The property crime rate was also more than twice as high in 1978 than today.

• While climate change is a serious concern today, localized water and air pollution was far worse in 1978, with lead still found within gasoline, and smog and acid rain constituting major problems.

To be fair, 2024 is worse than 1978 in some regards: housing affordability is a lot worse and the public deficit and debt are much larger, but the vibecession nevertheless overstates how bad things are for the average person.

We posit that the vibecession may become less acute in 2025 given additional optimism that appears to have been unlocked by the recent U.S. election (more on “animal spirits” in a moment), as lower interest rates improve housing affordability, as the trauma of high inflation fades further from memory, as inflation settles slightly further, and as the economy continues to grow.

3 – U.S. exceptionalism to persist

The U.S. has undeniably been the exceptional economy (and stock market) in recent years. There was some debate as to whether this exceptionalism might be fading in the middle of 2024, but that idea has since been snuffed out – the U.S. economy is moving nicely and is on track to deliver the fastest growth among major developed-world economies in 2025 (see next chart). To be sure, the U.S. growth advantage in 2025 may not be as large as in 2024, but it is more likely to persist than not, and in the last quarter we have been actively revising the U.S. forecast higher while some others such as the Eurozone and Japan have faced the opposite fate.

RBC GAM GDP forecast shows U.S. still ahead of other developed markets

As of 11/06/2024. Source: RBC GAM

There are both structural and cyclical reasons for the U.S. growth advantage. The structural advantages mainly revolve around two things.

1. The first is observational: the U.S. economy has already managed to significantly best its peers in both 2023 and 2024. Something significant would have to change to justify the view that the U.S. will be caught by the pack in 2025.

2. The second structural advantage is more fundamental: the U.S. is reliably delivering productivity growth at a time when most of its peers have been stagnating in recent years (see next chart). South Korea has been a rare exception, but it constitutes the exception to the rule. U.S. advantages such as the country’s enormous scale, top universities, competitive tax and regulatory environment, technological lead and risk-taking culture all position it well for the future.

Developed country labour productivity over time shows U.S. delivering steady growth

2024 data are forecasts from The Conference Board. Sources: The Conference Board Total Economy DatabaseTM, RBC GAM

The U.S. also has several cyclical growth advantages. The current technology and AI boom is centered in the U.S., with no sign that cap ex spending will abate, and with the prospect of productivity gains from this AI investment starting to appear over time. Fiscal policy should also be growth-supportive under the incoming administration.

Finally, the U.S. enjoys good economic momentum going into 2025. Illustrating this, the Atlanta Federal Reserve’s nowcast points to remarkable 3.3% annualized GDP growth in the final quarter of 2024.  Forward-looking business expectations have sky-rocketed from around -3 standard deviations to +2 standard deviations in a matter of months (see next chart). The future appears fairly bright for the U.S. economy in 2025.

U.S. business expectations composite have sky-rocketed

As of November 2024. Principal component analysis using National Federation of Independent Business (NFIB) optimism and business conditions outlook. Institute for Supply Management (ISM) Manufacturing and Services new orders and The Conference Board (TCB) CEO expectations for economy. Sources: TCB, ISM, NFIB, Macrobond, RBC GAM

4 - Animal spirits unleashed

There is the expectation of a positive growth impulse from Trump tax cuts and deregulation, albeit tempered by tariffs and curtailed immigration. What gets missed in the accounting analysis of growth-supportive and growth-impeding policies is the psychological element. John Maynard Keynes called this “animal spirits.” Today, animal spirits appear set to give the U.S. economy an additional boost as businesses have become quite excited about the future.

The level of optimism in the U.S. economy has leapt higher over the past several weeks, seemingly in response to the November election. Most remarkable among these, the National Federation of Independent Business’ (NFIB) Small Business Optimism Index has exploded from one of the worst readings of the past decade – where it had languished for multiple years – to the highest level since June 2021, and a level of outright optimism (see next chart). Measures of consumer confidence have also increased, if less sharply.

Small business sentiment supercharged by Trump’s win

As of November 2024. Shaded area represents recession. Sources: NFIB, Macrobond, RBC GAM

Whether entirely rational or not, these favourable animal spirits promise to unlock additional business investment and hiring, which is growth-supportive.

5 – Tricky inflation

Inflation has improved substantially over the past two years, and – when push comes to shove – we forecast a further improvement in 2025. But the 2025 outlook is a challenging one in that any improvement could be quite slight. For the U.S. in particular there is the risk that inflation doesn’t actually fall any further over the year.

Recent developments complicate the U.S. inflation outlook. A central problem is that the rate of inflation has ceased to descend in recent months. The November CPI (Consumer Price Index) data arrived +0.3% month-over-month (MoM) for both the headline and core indices, representing another above-target month (see next chart). As a result, headline inflation is now running at +2.7% year-over-year (YoY). Core inflation is +3.3% YoY – around a 3% clip.

U.S. Consumer Price Index (CPI) is rising

As of November 2024. Shaded area represents recession. Sources: U.S. BLS, Macrobond, RBC GAM

While gasoline prices have been up in recent months, the recent pickup in U.S. inflation has been somewhat broader than that (see next chart), with food prices and shelter costs also in the mix (see subsequent table). Furthermore, services inflation ex shelter, while cool in November, was notably warm in prior months such that the 3-month trend for this important component is again agitated.

U.S. inflation becoming broader

As of November 2024. Share of CPI components with year-over-year % change falling within the ranges specified. Sources: Haver Analytics, RBC GAM

Costs rising across many categories – especially Shelter and Services ex shelter

As of November 2024 for CPI and PPI (Producer Price Index) measures. October 2024 for PCE (Personal Consumption Expenditures) measures. Sources: U.S. Bureau of Economic Analysis (BEA), BLS, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Dallas, Macrobond, RBC GAM

It isn’t clear that shelter inflation can cool substantially further now that CPI rent has slowed down to that of market rents (see next chart).

CPI rent now closer to market rents

As of November 2024. Zillow Observed Rent Index includes rent prices for single-family and multi-family structures and leads by 12 months. Sources: U.S. Census Bureau, Zillow, Haver Analytics, Macrobond, RBC GAM

It is promising that corporate price-setting plans and wage growth have both cooled over the past few  years, but the improving trend has stalled out recently for both (see next two charts).

Fraction of U.S. businesses planning to raise prices perked up lately

As of November 2024. Shaded area represents recession. Sources: National Federation of Independent Business, Macrobond, RBC GAM

Wage growth in U.S. softened but still quite strong

As of November 2024. 3-month moving average of year-over-year percent change in average hourly earnings. Shaded area represents recession. Sources: BLS, Macrobond, RBC GAM

The prospect of fiscal stimulus combined with tariffs argue for a higher U.S. inflation forecast than otherwise. We have obliged by revising our outlook somewhat higher, from 2.3% annual average inflation to 2.6% in 2025. The inflation rate would be even higher, but we presume the Fed reduces rates more slowly in response, tempering the effect. The result is that U.S. inflation can decline slightly over the next year, but not a lot. Support for lower inflation in the near-term comes in part from this real-time inflation indicator, which argues that next month could be somewhat better (see next chart).

U.S. Daily Price Stats Inflation shows support for lower inflation

PriceStats Inflation Index as of 12/08/2024, CPI as of November 2024. Sources: State Street Global Markets Research, RBC GAM

The inflation outlook is somewhat cleaner for the rest of the developed world, with a modest further improvement anticipated. But even globally, inflation nerves are again on edge (see next chart). We assume inflation descends to levels that remain a hair higher than central banks’ 2.0% targets. Tariffs, of course, present an X-factor for all potentially affected parties.

Google searches on “inflation” are growing again

As of the week ending 12/14/2024 (partial data used for the week). The number of Google web searches for the topic relative to the highest point within the finance category for the region and time period selected. Sources: Google Trends, RBC GAM

The main inflation takeaway is that inflation should be able to descend slightly further, but this view is held with less conviction than a quarter or two ago.

6 –Rate cuts slow

It is still right to think about rate cuts for 2025, but the pace is set to be slower than in 2024, and slower than had been assumed as recently as a quarter ago.

The FOMC (Federal Open Market Committee) decision on December 18 seems all but locked in to a 25-basis-point rate cut. However, one could certainly make the argument that the combination of stronger-than-expected growth and stronger-than-expected inflation would justify a December pause instead. Fed Chair Powell himself recently spoke of the strength of the economy, upside inflation surprises, smaller downside risks and the ability to be more cautious in light of all of that.

The U.S. economy and inflation are unlikely to be in perfect equilibrium at the end of 2025. It should take longer to achieve that goal, with a neutral fed funds rate closer to 3.00% eventually in the crosshairs.

The sequence of rate cuts at adjacent meetings is probably going to end in the new year. A January 29 pause is now deemed more likely than not by markets, and we (and the market) budget for just three further 25-basis-point rate cuts spread across 2025.

That isn’t to say that the neutral level for the fed funds rate is 3.75%, but instead that the U.S. economy and inflation are unlikely to be in perfect equilibrium at the end of 2025. It should take longer to achieve that goal, with a neutral fed funds rate closer to 3.00% eventually in the crosshairs.

Other central banks are not as limited in their actions, as their growth tends to be softer, their economies already have some slack in them, and their inflation rate are already closer to target. Monetary easing is thus a simpler affair for them, though the pace of rate cuts should also be somewhat scaled back in 2025 versus 2024, and rate cuts in these countries should also be increasingly interspersed with pauses.

7 – “No landing” scenario on the table

For the longest time, when considering alternative outcomes to our base-case scenario, a recession was the primary alternative. This remains possible, but its odds continue to fall. We now budget for a mere 15% chance of recession over the next 12 months in the U.S.

Our base-case scenario – a soft landing in which the economy slows moderately and inflation tempers – has a likelihood of around 60%, leaving the 25% chance of a “no landing” outcome.

A “no landing” refers to the economy growing in a sufficiently vigorous fashion that it finds itself above the economy’s sustainable potential, resulting in inflation that remains too high and a Federal Reserve that is limited in its rate cutting ability, precluding it from cutting or – in an extreme version of the scenario – forcing it to raise rates.

As the probabilities imply, we now believe this “no landing” scenario is more likely than a recession.

We now budget for a mere 15% chance of recession over the next 12 months in the U.S.

It should be conceded that the “no landing” and the recession scenarios are inherently temporary affairs. Economies do not overheat forever, nor do they fall into perpetual recession. A “no landing” scenario would prevent inflation from falling, preclude the Fed from cutting and this would eventually force the economy to slow down – possibly even overshooting into a contraction on the way down. At that point, inflation and rates would fall. But the message is that, in the meantime – for 2025, anyway – there is a scenario in which growth, inflation and rates all remain higher than markets are assuming.

8 – Tariffs, but how much?

The real theme here should perhaps be U.S. public policy more generally, as there remain questions around the exact nature of quite a range of proposed initiatives, from tax cuts to deregulation to immigration to tariffs.

But, realistically, the largest questions relate to the nature of the tariffs set to be imposed by the U.S. on its trading partners. We wrote about some of the recent Trump tariff threats in the prior MacroMemo, and have previously estimated their economic impact.

It is natural to become more nervous as January 20 approaches. There has been much more talk about tariffs than about Trump’s other policy ideas since the election. Furthermore, his proposals have been – if anything – bolder than what was discussed on the campaign trail. Mexico and Canada have been subjected to the most acute near-term threats, but U.S. and Chinese growth are also significantly in question, as is Vietnam. The economic danger is also considerable elsewhere, if a notch lower for jurisdictions such as the Eurozone, the UK and Japan.

Still, we continue to believe these tariff proposals are best interpreted as a negotiating strategy for wringing concessions from other countries. We are reassured by the fact that this was primarily how tariffs played out in 2017-2020. Mexico and Canada have been asked to fortify their borders and are in a position to comply. Other pressure points may include military budgets, procurement of U.S. goods and other countries’ industry subsidies and protectionist policies.

That said, significant temporary tariffs are possible, and our global growth forecast already assumes a permanent if moderate increase in tariffs.

9 – Chinese resilience

In the context of a stumbling Chinese economy that is limited by weak housing (see next chart), poor demographics, a downtrodden private sector and frictions with the U.S., we continue to think pessimism about China may be at least slightly overblown.

Exports remain the bright spot in China’s growth

As of October 2024. Average of 2019 levels indexed to 100. Sources: Haver Analytics, RBC GAM

First, while U.S. tariffs constitute a genuine threat, Chinese exports are highly diversified. The North American market only generates 15.9% of foreign demand for Chinese products (see next chart). There is enormous demand from Asia and Europe, in particular. Given China’s large domestic market, just 2.5% of what China makes transits directly to the U.S. This argues that China may be more resilient than commonly imagined in the face of additional tariffs.

Chinese exports are highly diversified

As of October 2024. Sources: China General Administration of Customs (GAC), Macrobond, RBC GAM

Second, Chinese fiscal and monetary policymakers have historically been among the most competent in the world. They have arguably lost their way in recent years, but it is reasonable to think that they will regain their bearings as the imperative to support their economy mounts. Although recent stimulus announcements have underwhelmed, the country still has sufficient fiscal and monetary policy space to deliver significant additional economic support, along with a softer currency that would also help the country’s competitiveness.

It was notable that China recently changed its desired monetary policy stance from “prudent” to “moderately loose”, constituting the first change in a remarkable 14 years. Similarly, policymakers have spoken of the need to “vigorously boost consumption, improve investment efficiency and expand domestic demand in all directions.” We assume that additional stimulus will be announced once the U.S. has clarified its tariff plans for China in the first quarter of 2025.

10  - Geopolitics in focus

As with 2024, geopolitics are likely to remain in focus in 2025, if of uncertain relevance to the global economy and markets.

The war in Ukraine has intensified as both countries jostle for positioning before a Trump administration attempts to secure a cease-fire. Should a cease-fire succeed, the level of uncertainty would decline in the short run (if not in the long run, with Russia potentially emboldened). However, if a cease-fire fails, U.S. support of Ukraine may decline, upending the battlefield unless European nations swoop to the rescue.

The conflict in the Middle East continues to ramp up, with Syria’s long-time dictator Assad recently ousted. The question is what comes next? While all hope for a new era of peace and tranquility, the reality is that a number of factions, some unsavoury, now contest a fragmented Syria. Iran is weakened, which could render it more volatile in its actions. Oil prices have increased somewhat, though it remains remarkable how minimally affected the price of oil has been in the grand scheme, despite roiling conflict across the Middle East.

Tariffs also constitute a form of geopolitical action. They appear set to increase the level of economic conflict between countries.

11 - Choppy Canada

The Canadian economy has been soft recently. The country reported just +1% annualized GDP growth in the third quarter. The unemployment rate has now increased from a 2022 low of 4.8% to an elevated 6.8% today (see next chart).

Fortunately, forward-looking indicators such as the Business Outlook Survey and the CFIB (Canadian Federation of Independent Business) Business Barometer both point to a slight improvement ahead. This is consistent with the advantage gained from a rapidly falling policy rate.

Canadian unemployment rate is rising fairly quickly

As of November 2024. Shaded area represents recession. Sources: Haver Analytics, Macrobond, RBC GAM

So where does the theme of a choppy Canada come in? That is mostly to do with three things: the trajectory of immigration, productivity and tariffs.

The first two of these are intertwined. High immigration in recent years has added to the workforce but arguably quieted productivity growth. The hope is that as recent government policy changes to sharply slow immigration take effect, productivity will symmetrically revive (see next chart).

Canadian growth has been driven by working more hours rather than improving productivity

As of Q3 2024. Sources: Statistics Canada, Macrobond, RBC GAM

This handoff is entirely possible, and more generally productivity has been so weirdly subdued in Canada in recent years that the primary magnetic attraction must surely be toward faster productivity growth, even without heroic policy efforts.

But we do flag the potential for unusually bumpy economic activity over the next several quarters. Most likely is that immigration declines promptly but productivity takes longer to revive. This could leave a quarter or two of minimal growth or even contracting economic output.

We do flag the potential for unusually bumpy economic activity over the next several quarters. Most likely is that immigration declines promptly but productivity takes longer to revive.

The third variable – tariffs – constitutes an entirely different threat to Canadian growth. It also happens to be frontloaded over the next several quarters. Unexpectedly, Canada almost appears to be Trump’s main tariff target based on a string of recent comments.

If significant tariffs were to hit the Canadian economy in January 2025, substantial damage would result. In the unlikely event that a full 25% blanket tariff were applied to Canada, a recession would be highly likely. If lesser tariffs were applied, the damage would be less. But at a time of minimal population growth, the risk of a quarter or two without economic growth again presents itself.

With regard to the economic impact of different U.S. tariff options, Canada’s energy sector generates by far the largest share of exports to the U.S. (31%), with the implication that tariffs on this sector would be particularly damaging (see next chart). Tariffs on vehicles (15.8% of Canadian exports to the U.S.)  or manufactured goods (23.9% when the two non-vehicle varieties are combined) would also be quite problematic for the broader economy. Agriculture and food products (12.1% of exports) and metals (8.9%) are a smaller share, but still highly significant.

Energy leads Canadian merchandise exports to U.S.

As of October 2024. Sources: Government of Canada, Department of Innovation, Science & Economic Development, Macrobond, RBC GAM

Geographically, Alberta and New Brunswick are the most reliant on U.S. demand (34% and 33% of provincial GDP, respectively), followed by Saskatchewan (25%) and Ontario (18%). Quebec has a lesser 15% orientation and the British Columbia connection is a surprisingly small 7% of GDP.

When the Trump administration last applied tariffs to Canada – in 2018, on steel and aluminum – Canada responded proportionately, with tariffs on U.S. steel and an assortment of other products designed to apply maximum pressure on American politicians. The deadlock was ultimately resolved when the USMCA (U.S.-Mexico-Canada Agreement) trade deal was signed a year later.

This time, Canada is again contemplating how to retaliate. One would imagine that tariffs like those applied to the U.S. in 2018 are under consideration. Another idea that has been floated is to apply export taxes to Canadian products crossing the border into the U.S.

On the surface, this is little different than the tariffs the U.S. threatens to hit Canada with, only the Canadian government collects the tariff rather than the U.S. government. But there is another important difference, which is that Canada could target critical U.S. needs such as Canadian oil, uranium and potash, with an eye toward making the U.S. tariffs sufficiently unpopular that a quick resolution is secured. The Ontario government has also talked of blocking certain electricity exports to the U.S.  Naturally, these ideas have not proven popular with the Canadian sectors that would be adversely affected, and it is not at all clear that these ideas will actually be implemented.

Plus Canadian economic issues

A few quick additional thoughts on Canada which land outside of the context of “Key themes for 2025”.

Bank of Canada rate cut

The Bank of Canada (BOC) delivered a second-consecutive 50-basis-point rate cut in December. BOC has now cut Canada’s overnight rate by 175 basis points since June, from 5.00% to just 3.25%. This makes the BOC the most aggressive of the major developed-world central banks, and means Canada has moved much more quickly than the U.S. (see next chart).

This is arguably fitting given that Canadian inflation is on target, unemployment is elevated and the country suffers from a high degree of interest rate sensitivity, with many mortgages resetting into substantially higher rates over the next two years.

North American monetary policy in easing mode

As of 12/13/2024. Shaded area represents U.S. recession. Sources: Macrobond, RBC GAM

From here on out, the BOC spoke of a “more gradual approach.” Indeed, we and the market both budget for only a few more rate cuts across 2025. That would imply that the policy rate should settle in the mid-to-high 2% range.

Canada-U.S. growth gap

Historically, U.S. and Canadian GDP growth have been strikingly similar over the decades (see next chart). Deviations have occurred, but they have tended to be fairly small and short-lived.

Canadian and U.S. growth normally move in sync

As of Q3 2024. Sources: Statistics Canada, U.S. Bureau of Economic Analysis (BEA), Macrobond, RBC GAM

It has thus been notable that U.S. growth over the past two years has significantly outpaced Canada. The gap would have been even larger if it weren’t for Canada’s recent rapid population growth – an external factor. We attribute Canada’s underperformance to the country’s greater interest rate sensitivity plus U.S. primacy over the recent tech and AI boom.

While such deviations between the two countries are not common, neither are they unprecedented. We identify two other large deviations over the past 40 years:

1. The first was in 2015—2016, when Canada again grew considerably less quickly than the U.S., that time during an oil bust.

2. The second extended from the late 1980s through the early 1990s. Canadian and U.S. growth both decelerated and then accelerated, but Canada chronically lagged across the episode. We postulate that this was the result of declining global commodity prices, a more hawkish BOC that embraced inflation targeting first, and – at least over the latter part of the experience – a Canadian housing bust.

In summary, the drivers were entirely different in each of the three episodes. There was no single recipe. In the two earlier episodes, growth subsequently converged with Canada accelerating up to the U.S. This would argue that Canadian growth should not lag the U.S. indefinitely, though it is likely asking too much for 2025 to be the year of substantial convergence.

-With contributions from Vivien Lee and Aaron Ma