After three months of conflict, the United States and Iran reached an interim agreement to reopen the Strait of Hormuz. The deal represents a potential first step toward easing the global energy shock. Reflecting optimism around the resumption of commercial traffic through the Strait, WTI crude oil prices fell below USD 70 per barrel (/bbl) last week after averaging over USD 100/bbl in May. If sustained, the fall in energy prices may provide relief for consumers and reduce an important source of inflationary pressure. However, the deal is fragile, and prospects for ending the war are highly uncertain. Even if the ceasefire holds, it could take months for trade flows through the Strait to return to prewar levels.
Despite the economic headwinds generated by the conflict and the ongoing uncertainty around how negotiations will evolve, the US looks set to post another year of solid growth. Our baseline forecast is for the economy to expand by 2.1% in 2026 and 2.0% in 2027. This resilience partly reflects how the US (as well as Canada) is a net energy exporter and therefore comparatively less exposed (in aggregate) to the energy price shock.
But the US growth performance is primarily driven by other factors. Investment is booming amid a surge in AI-related capital expenditure and the requisite buildout of energy infrastructure. US consumers have continued to spend even as real incomes have taken a hit, with real retail sales expanding at a robust pace in April and May. Credit card spending has not shown any signs of a pullback either. Larger tax refunds and rising equity valuations have helped sustain consumer spending. The US Treasury disbursed USD 50 billion more in tax refunds through the first week of May 2026 relative to a year ago.
Looking to the second half of the year, the US growth outlook is generally positive. Business investment plans look strong, and lower gasoline prices, if sustained, will support consumers’ purchasing power and help offset the fading tailwind from tax refunds.
Canadian Economy Set to Gain Position Momentum
While the US economy is running close to or above capacity, the Canadian economy stagnated in early 2026 and is operating in excess supply. Real GDP contracted by 0.1% at an annualized pace in the first quarter, following a 1.0% decline in the fourth quarter of 2025. This lackluster performance was partly driven by a shrinking population and sluggish business investment. Nevertheless, the headline readings may overstate the economy’s weakness, as inventories played a large role and severe winter weather acted as a drag. High frequency indicators suggest that activity picked up in the second quarter. We expect the economy to gain momentum in the second half of the year on the back of a stabilizing labor market and improving household purchasing power. Taken together, the Canadian economy is forecast to expand 1.1% in 2026 and 1.8% in 2027.
Risks to the near-term growth outlook skew to the downside. First, an escalation in the US-Iran conflict that effectively closes the Strait could sharply increase energy prices and stress global supply chains. Even when accounting for the income gains to North American energy producers, elevated energy prices would increasingly act as a headwind to growth as higher costs would squeeze households’ real incomes and firms’ profitability. Second, a change in market expectations regarding the return on technology investments could sharply lower capital spending plans and prompt a correction in the equity markets, thereby reducing consumption. Third, US trade policy is an ongoing source of uncertainty. While we expect the USMCA will remain in place and largely retain its current form, its termination would generate considerable investment uncertainty and weigh on the US and Canada’s growth outlooks.
Job Markets Face Shifting Supply and Demand for Labor
The US labor market appears to be operating close to balance. The unemployment rate held fairly steady at 4.3% through the first five months of the year, and the prime age employment rate remained above 80.0%. Both indicators are consistent with a labor market that is near full employment. Despite some concerns about the strength of the labor market in early 2026, the acceleration in payroll increases over the last three months suggests that the jobs market remains on a solid footing.
Overheating concerns also appear premature. Slowing wage growth and a benign quits rate suggest workers’ bargaining power has weakened relative to last year. While hiring activity will likely slow in the second half of the year, weaker labor supply growth, largely driven by more restrictive immigration policies, should keep the unemployment rate relatively low.
The supply and demand for workers in Canada is cooling, too. Over the last six months, the labor market has experienced cumulative net job losses. Weak demand for workers has been accompanied by stagnant labor force growth. The latter is partly due to the shift in government immigration policy, which aims to reduce the share of non-permanent residents to less than 5% of the population. Population estimates declined in each of the last three quarters. Against this backdrop, the unemployment rate has remained relatively stable, even as net job creation halted, hovering around 6.5-7.0% through the first half of 2026.
Peaking Headline Inflation Masks Underlying Inflation Dynamics
Headline PCE inflation jumped to 4.1% year over year in May due to surging gasoline and fuel prices. With global energy prices receding, the limited spillover of higher fuel prices to other goods and services so far suggests inflation has probably peaked. However, in the US, bringing inflation down to the 2% target will likely take time, due to the strength of underlying demand. Core PCE inflation was 3.4% in May. Given our expectation of solid near-term growth, non-energy inflation could prove to be sticky. That said, we expect core pressures to gradually ease over the next 12-18 months as modest house price appreciation feeds into lower housing inflation, the impact of tariffs on goods prices wanes, and wage growth remains soft.
In Canada, a persistent negative output gap should help contain core price pressures. Annual headline inflation increased to 3.2% in May on higher energy prices. Even with the temporary suspension of the federal fuel excise tax introduced in April, gasoline prices increased 33% year over year. However, underlying price pressures in Canada look more benign than in the US. Most core inflation measures are running close to 2%. Even as the Canadian economy strengthens in the second half of 2026 and into 2027, we expect inflation to remain around the central bank’s target.
Federal Reserve and Bank of Canada Will Likely Take a Breather
The Federal Open Mark Committee left the federal-funds rate unchanged at 3.50%-3.75% on June 17. It was the Federal Reserve’s fourth consecutive hold. According to the Summary of Economic Projections, FOMC participants were largely split between those who expect rates to remain unchanged or cut by year-end and those who expect at least one 25-basis-point hike. We expect the Fed to remain on hold during the second half of the year. Given the resilience of the labor market and the persistence of above-trend core inflation, the case for rate cuts has weakened since the start of the year. However, with few signs of overheating in the labor market and with inflation expectations anchored, the case for rate hikes does not appear conclusive either.
Similar to the Fed, the Bank of Canada held the overnight rate steady at 2.25% at its June meeting. This places the policy rate at the lower end of the Bank’s estimated neutral range (2.25%-3.25%). With a negative output gap and few signs that the energy price shock is being passed through to other non-energy items, we expect Bank of Canada policymakers to wait until there is greater evidence of an economic recovery before making further adjustments to the overnight rate. If activity strengthens and economic slack materially diminishes, policymakers may shift toward the midpoint of the neutral range over the course of 2027.
