08:25 AM EST, 02/28/2025 (MT Newswires) -- While Canada's response to United States trade tariffs could be multi-pronged, fiscal policy is under-appreciated and might be the ace in the hole, said RBC.

Whether or not there are retaliatory measures, fiscal and monetary policymakers should err on the side of patience, noted the bank. The impact of tariffs won'tt be immediate. If implemented, the duration that tariffs remain in place is uncertain and over-stimulating the economy -- especially with potentially constrained supply -- risks an adverse outcome, in other words inflation, that was painfully evident following the pandemic.

While the tariff threat has introduced long-term uncertainty that can be a prolonged drag on business investment and hiring, until the magnitude is quantifiable, it will be impossible to properly calibrate policy -- the lesson learned from COVID-19, stated RBC. At least starting out smaller will reduce the risk of overdoing it.

The Bank of Canada estimates the gross domestic product hit from a global trade war -- 25% U.S. tariffs with full retaliation -- would lower Canadian GDP by 2.4% in year one and 1.5% in year two. The growth hit would be larger, to an unknown magnitude, if only Canada and Mexico were targeted -- assuming 3% in year one and 2% in year two.

Deficits during COVID-19 (federal and provincial) in FY2020-21 expanded by C$320 billion, or 13% of GDP, with spending increases disproportionately from the federal government (spending as a percentage of GDP increased by 13pp) compared with provincial (1pp-4pp increase). Once COVID-19 subsided, fiscal deficits quickly returned to more normal levels.

To offset the negative impact from tariffs -- assuming they were just applied to Canada and Mexico -- might require additional spending/larger deficits of around C$90 billion in year one and C$60 billion in year 2 -- like the Gobal Financial Crisis response, but well short of COVID-19 spending. Like COVID-19, the bulk of fiscal support (about 75%) might fall on the federal government.

Canadians loathe deficits, but growing nationalism in the face of an existential crisis makes government spending a palatable policy choice, added RBC. Deficits are probably set to rise no matter what -- fiscal policy to offset actual tariffs, incentives for business investment to cushion the blow from tariff threats, military spending, or additional border security measures.

Fiscal spending and associated higher issuance would, all else equal, portend higher bond yields, wider provincial spreads, tighter swap spreads, and Government of Canada underperformance versus U.S. Treasuries, according to the bank. But the fallout is probably "manageable and nuanced."