As yet, it is unclear whether widespread tariffs will become a reality or are more a threat designed to rebalance trading relationships and gain negotiating power on other issues (the recent decision to freeze tariffs on Canada and Mexico for 30 days while leaving in place those on China did not resolve this question). But let’s be clear: an extensive round of tariffs will damage global trade, with manufacturing hit particularly hard. Trade wars ultimately hurt businesses and consumers in all countries involved.
Some of the arguments used to justify tariffs are rooted in the decline of US manufacturing. Free trade has hollowed out the US’ manufacturing base, with inevitable consequences for jobs, national security and a loss of expertise in some areas. At the same time, some of the US’ largest trading partners have employed industrial practices designed to give them a competitive advantage in certain industries. So while new tariffs from the US would be highly unlikely to have a positive economic impact, they may have some justification from a political perspective.
Politics aside, however, the prospect of a new round of tariffs has tossed an extra variable into the global economic outlook. Without the uncertainty related to tariffs, the growth picture appears mixed but not unduly alarming: the US seems set for another year of solid growth, China has provided some stimulus to support its economy, and although Europe may suffer a slowdown in the first half of the year, the European Central Bank is well positioned to respond swiftly with rate cuts. A recovery in Europe in the second half of the year is highly plausible, while long‑term structural developments, including the push towards renewable energy and “friendshoring”, should provide further support for the global economy.
Depending on their severity, new tariffs could undermine this relatively benign outlook. As with any other tax hike, an increase in tariffs is a demand shock. It reduces overall income in the economy (known as the income effect) and distorts demand by reducing the consumption of certain goods while increasing the consumption of others (the substitution effect), resulting in inefficient production and consumption patterns. Overall, the economy loses.
Tariffs also cause uncertainty over future spending. If a European firm plans to spend US$1 billion building a factory to export goods to the US, it will want to know under which terms it will be allowed to trade with American customers. When there is any doubt over these terms, it makes sense to defer the investment until the conditions for trade have been clarified. In a sense, economic uncertainty works in a similar way to an interest rate hike: firms delay lumpy consumption and capital expenditure and postpone hiring.
Why tariffs are bad for global growth
The imposition of tariffs not only affects the behaviour of corporations and households, it also requires a response from governments. For example, if the US imposed a tariff that reduced its consumption of foreign‑produced widgets, the rest of the world would experience a negative demand shock. A negative demand shock increases the output gap in the rest of the world and leaves it with excess labour and production capacity.
When the output gap increases, a free market and open economy adjusts in two ways: First, inflation slows due to softer demand and interest rates decline as a result; second, the exchange rate depreciates, which enhances international competitiveness and boosts external demand. With lower rates and a cheaper exchange rate, an equilibrium framework dictates that the output gap is closed through a combination of net softer external demand and stronger domestic demand.
However, despite a widespread perception that tariffs are inflationary, the evidence for this is unclear. By definition, inflation is a persistent increase in the pace at which prices are adjusted. By contrast, a tariff is a one-time increase in price level – not a sustained shift in the rate of inflation. Tariffs may turn inflationary if they raise inflation expectations, particularly during periods when inflation is already high and the economy is operating close to full capacity. However, there is little evidence to suggest that the imposition of a one-time tariff on goods has a long‑term inflationary impact.
Stronger dollar, weaker equity markets
One of the most immediate asset class implications of new tariffs from the US would be a stronger US dollar (because tariffs on imports invariably appreciate the home currency). In response, foreign central banks will ease policy, resulting in currency depreciation. Even countries whose central banks cannot cut rates will likely see their currencies depreciate as foreign exchange markets tend to chase growth.
In bond markets, tariff expectations have so far led to higher inflation expectations and an increase in long‑end yields. But if the focus were to shift to negative impact of tariffs on growth, the yield curve would likely steepen as reduced growth expectations would raise expectations of rate cuts. It is worth noting that the policy response in the US will initially diverge from that in the rest of the world: as higher tariffs will only affect the price level and are unlikely to result in sustained inflation, the US Federal Reserve (Fed) is likely to remain cautious as it monitors the impact on inflation expectations. The continued resilience of US growth also means the Fed is under less pressure to ease rates.
However, I do not believe that the Fed will end up tightening monetary policy as a result of new tariffs: tariffs likely will hit the American consumer much as a value‑added tax (VAT) hike would. While tariffs may drive up domestic demand for some US‑produced goods and services, a VAT increase is a tightening of the fiscal stance and it is rare for a fiscal tightening to lead to further economic overheating.
As the imposition of tariffs takes a toll on economic growth, growth‑sensitive assets such as equities are likely to suffer in a regime that relies on the widespread use of tariffs. Further, the increase in economic uncertainty that is associated with tariffs is likely to raise the risk premium investors demand to hold risky assets – an additional headwind to equities. Should the equity market fall in response to the imposition of tariffs, financial conditions will tighten, raising the likelihood of central banks being forced to ease policy. However, some of these effects on US businesses could be offset by a favourable budget deal and further corporate tax cuts which, in my view, are reflected in the market pricing. The sequencing of fiscal and trade policy implementation will be important to ensure that the positive growth trajectory in the US continues.
We should remind ourselves again that while negotiations over tariffs are still taking place, any discussion of their ultimate impact is somewhat speculative. A key outstanding question is whether new US tariffs would result in a large‑scale global trade war. If the US targeted a few smaller, select countries, a global trade war would almost certainly be avoided. However, if the Trump administration decided to pick a trade fight with the entire world or the largest economies in the rest of the world (China and the EU), large‑scale tariffs on US exports would be far more likely and the ramifications would be felt globally.
The prospect of a global trade war that benefits nobody should factor into the US’ thinking on tariffs. Whether it does remains to be seen.
Blerina Uruci, chief US economist, fixed income, T. Rowe Price
