Deglobalization and Trade Fragmentation: Implications for the Inflation-Output Trade-Off

The global economy is entering a period of greater volatility and structural change, with rising geopolitical fragmentation and a partial reversal of decades-long globalization trends. This note examines the implications of deglobalization and trade fragmentation for the Bank of Canada's flexible inflation-targeting framework, focusing on the inflation–output trade-off faced by a small open economy. Using a two-country, multi-sector general equilibrium model calibrated to Canada and the United States, we trace how trade-cost shocks propagate through production networks and assess the monetary policy trade-offs they generate. A bilateral 10 percentage-point increase in trade costs produces a non-trivial trade-off: fully stabilizing CPI inflation over a two-year horizon requires accepting a 0.16% reduction in output relative to potential, while fully closing the output gap implies tolerating a 0.32 percentage-point increase in inflation. The severity of the trade-off depends on shock size and persistence, on whether tariffs target final or intermediate goods, and on the inflation measure the central bank stabilizes. For trade-cost shocks of magnitudes comparable to recent policy measures, the existing framework retains sufficient flexibility to return inflation to target within the standard horizon. Larger or more persistent shocks, however, would make "look-through" policies costlier and raise the risk of expectation de-anchoring.