Ottawa, Canada – August 29, 2025 – Canada’s economy shrank by 1.6% on an annualized basis in the second quarter of 2025, marking its first contraction in nearly two years and the steepest decline since the COVID-19 pandemic, according to data released by Statistics Canada on Friday. The downturn, driven primarily by a sharp drop in exports amid escalating trade tensions with the United States under President Donald Trump, reversed the 2.0% growth (downwardly revised from 2.2%) recorded in the first quarter. This left overall GDP growth for the first half of the year at a meager 0.4%, underscoring the severe impact of tariffs on the nation’s export-dependent economy. While household and government spending provided some cushion, economists warn that the trade war’s ripple effects could push Canada toward a recession, with the Bank of Canada now facing heightened pressure to cut interest rates at its September 17 meeting.
The Trade War’s Crushing Blow: Exports Plunge Amid Tariffs
The contraction was overwhelmingly attributed to the ongoing U.S.-Canada trade war, which intensified after Trump’s January 2025 inauguration. The U.S., Canada’s largest trading partner accounting for about 75% of its exports, imposed a series of tariffs starting in February, including 25% on automobiles and parts, 50% on steel and aluminum, 10% on energy and potash, and broader 25-30% duties on non-compliant goods under the USMCA (formerly NAFTA). In retaliation, Prime Minister Mark Carney’s government suspended most countermeasures in April to de-escalate, but the damage was already done – Canadian exports plummeted 7.5% in Q2, the largest quarterly drop in five years, following a temporary 1.4% surge in Q1 as businesses front-loaded shipments to beat impending tariffs.
Key sectors bore the brunt: Exports of industrial machinery, equipment, and parts fell 18.5%, while travel services declined 11.1%. Motor vehicles and energy products, which comprise a significant portion of bilateral trade, saw sharp reversals after the initial rush. Imports dropped 5.1%, narrowing the trade deficit slightly but exacerbating supply chain disruptions. Statistics Canada noted that the export slump contributed nearly 2.5 percentage points to the GDP decline, with business investment contracting 10.1% – the weakest since 2016 outside the pandemic – as companies postponed expansions amid uncertainty.
The data aligns with broader trends reported earlier in 2025. For instance, Canada’s trade deficit swelled to a record high in April, with U.S.-bound exports hitting their lowest levels since the pandemic. By May, total exports rose modestly 1.1% due to record shipments of unwrought gold to non-U.S. markets, but U.S. exports continued to tank, down 15% from Q1 peaks. Bank of Canada Governor Tiff Macklem highlighted in a June speech that tariffs on intermediate goods, like auto parts crossing the border multiple times, amplify costs and reduce competitiveness, leading to a 2.1% long-term GDP hit per Yale Budget Lab estimates.
Domestic Resilience Offers Limited Relief
Despite the export carnage, final domestic demand – a measure of internal economic activity – rose 3.5% in Q2, providing a partial buffer. Household consumption surged 4.5%, accelerating despite a slowdown in population growth from 3.9% year-over-year, driven by resilient spending on essentials amid cooling inflation. Residential investment climbed 6.3%, fueled by ongoing housing initiatives, while government final consumption expenditure jumped 5.1%, supported by federal programs like accelerated infrastructure and defense spending to counter tariff impacts.
Monthly data offers glimmers of stabilization: June’s economy contracted 0.1%, marking three straight months of decline and the first such streak in three years, but preliminary July figures show a rebound to 0.1% growth, led by goods-producing industries. Compensation of employees grew just 0.2%, the slowest since 2016, pulling household savings down to 5% from 6%, while federal government net borrowing accelerated due to a 4.2% revenue drop from the April 1 carbon tax removal and 1.8% spending increase.
Regionally, the pain is uneven. Export-heavy provinces like Ontario and Alberta – reliant on autos, energy, and manufacturing – face the sharpest hits, with manufacturing output up modestly in February but slumping thereafter. British Columbia benefits from diversification and resource strength, projecting 1.2% growth, while Atlantic provinces like Nova Scotia (1.6%) lean on public sector investments. Overall, Canada’s real GDP per capita remains below pre-pandemic levels, with business productivity lagging the U.S. by half since the early 2000s.
Implications for Monetary Policy and Recession Risks
The Q2 contraction, worse than the 0.6% forecast by Reuters economists and slightly below the Bank of Canada’s 1.5% projection, has amplified calls for rate cuts. The benchmark policy rate stands at 2.75%, the midpoint of neutral, but money markets now price a 48% chance of a September cut – up from 40% pre-report – with expectations for two more by year-end if slack builds. CIBC’s Andrew Grantham noted weak Q2 momentum into Q3, while TD Bank’s Rishi Sondhi sees “excess supply” paving the way for easing to combat downward inflation pressure.
Oxford Economics forecasts a 2025 recession, with growth at 0.9% (down from earlier estimates) and 0.3% in 2026, citing tariffs’ $2,600 annual household cost hit. Unemployment, already at 7.4% in May, could average 7.2%, with job losses in trade-exposed sectors like manufacturing (down in Ontario) offsetting gains elsewhere. Inflation, at 2.8% CPI in recent data, faces dual pressures: tariffs pushing prices up (e.g., via intermediate inputs) while excess supply pulls them down, per Macklem’s analysis.
The Canadian dollar weakened 0.17% to 1.3771 against the USD post-report, while two-year bond yields fell 2.8 basis points to 2.664%. TSX futures dipped, reflecting export woes, but domestic resilience tempers broader market panic.
Broader Context: A Wake-Up Call for Diversification
The trade war’s fallout echoes earlier warnings from the Bank of Canada, which in January 2025 modeled a 2.1% GDP drag from full tariffs, including job losses and inflation spikes. Front-loading in Q1 (exports up 10%) borrowed from future growth, leading to Q2’s payback. Macklem emphasized in March that uncertainty alone chills investment, with non-residential business investment 9% below pre-COVID per capita levels.
Efforts to diversify – boosting exports to Asia via LNG Canada’s June startup (targeting 14 million tonnes annually) and non-U.S. markets – show promise, with May’s gold exports to the UK hitting records. However, reliance on the U.S. (75% of exports) remains a vulnerability, as seen in the 15% drop in U.S.-bound goods since February. Federal support, including worker aid and infrastructure acceleration, aims to mitigate, but economists like McGill’s Julian Karaguesian call it a “wall of uncertainty” stifling planning.
Globally, this mirrors U.S. challenges, where tariffs contribute to 2.9% core PCE inflation. For Canada, the path forward hinges on USMCA renegotiations in 2026 – Trump has threatened 35% duties if no deal is reached – and domestic reforms to boost productivity, long a Canadian Achilles’ heel.
Outlook: Recession Risks and Policy Responses
With Q3 potentially improving to 0.1% monthly growth in July, Canada avoids immediate recession but teeters on the edge. RBC Economics projects national growth at 1.2-2.2% for 2025, moderated by tariffs but buoyed by resources in provinces like Saskatchewan (2.2%). The BoC’s next moves – monitoring jobs and CPI – will be pivotal; further easing could support households tested by resilient-yet-strained consumption.
As Carney’s government pushes diversification and Carney negotiates with Trump (aiming for a July 21 deal, per earlier reports), the Q2 data serves as a stark reminder: Trade wars hurt everyone, but export-reliant economies like Canada’s most. Sustained U.S. tariffs could shave 0.5 percentage points off growth annually, per BMO, underscoring the urgency for resolution.
For more details, visit StatisticsCanada.gc.ca or Bloomberg.com.