Higher Tariffs Are Here to Stay

Summary

• Tariff increases are likely to proceed on two tracks. The long-term track is broad based, gradual and meant to generate revenues and support reshoring.
• Meanwhile, the ‘opportunistic’ track is country specific, aggressive and meant to exert leverage on trade partners.
• The ongoing ‘opportunistic’ tariff increase has created new policy uncertainty and delayed this year’s planned Fed cuts.

Market Implications

• I still expect no cut in 2025 against markets pricing about 1.9 cuts.

Higher Long-term Tariffs Support Reshoring and Revenues

During his confirmation hearing, Treasury Secretary Scott Bessent explained that tariff policy had three objectives: revenue generation, reshoring, and leverage in trade negotiations. Here, I provide a framework for tariff policy and argue large, permanent tariff increases are likely.

The revenue generation and reshoring objectives are long term and therefore require a permanent increase in tariffs. Also, this is likely to lift prices, possibly inflation (more on this below), and lower growth.

This is because higher tariffs imply businesses and households pay higher prices, though the passthrough is unlikely to be 1:1. A 1:1 passthrough from tariffs to end-buyer would require exporters, importers, wholesalers and retailers to keep prices and margins constant, which the 2018-19 tariff increases show is unlikely.

Most importantly, passthrough from higher tariffs to US prices is required to encourage US businesses to invest in new product lines to compete with imports. The Trump administration hopes this will translate into a manufacturing revival and a stronger economy long term, the short term short-term pain and long-term gains President Donald Trump mentioned on Truth Social.

In fairness to the administration, the trade deficit has been worsening for the past decade (Chart 1). The loss of American exporters’ competitiveness is especially striking for capital goods, where America’s technological edge has not prevented the emergence of a growing deficit. Yet, improving America’s competitiveness could require, besides higher tariffs, more efficient regulations, stronger domestic competition, and industrial policy, all of which the administration seems intent on implementing.

To minimize short-term negative consequences of tariffs, the administration is likely to implement them gradually and predictably. For instance, by announcing a schedule of gradual increases.

Higher Tariffs Could Generate Substantial Revenues

In FY2024, customs duties generated $77bn or 2.4% of imports and 1.6% of total budget revenues (Table 1). During his campaign, Trump announced he would implement a universal baseline increase in tariffs of 10-20%.

These long-term tariff increases would likely be implemented through the budget, which Congress aims to have enacted by mid-year. For this, the House and Senate should adopt a resolution presenting the broad budget parameters this month.

Chart 2 and Table 1 presents implementation scenarios over 18 months starting in July when I expect the new budget to become effective:.

• In the high scenarios, average tariffs are raised by 1ppt/month, which translates into an increase in an average tariff to 20% by end-CY2026 and tariff revenues of $420bn in FY2026 (ending in September 2026).
• In the low scenarios, average tariffs are raised by 0.5ppt/month, which translates into an increase in an average tariff to 10% by end-CY2026 and tariff revenues of $250bn in FY2026.

However, this marked increase in tariff revenues would fund only part of Trump’s tax cuts (Table 2). In addition to extending the Tax Cuts and Jobs Act (TCJA) cuts that expire at end-CY2025, Trump wants to exempt social security income, overtime and tips from taxation as well as restore the state and local tax (SALT) exemption.

My tariffs scenarios may seem high because the actual tariffs are likely to be. The administration intends to implement a root-and-branch transformation of the US economy to make it more private sector-driven, more domestic focused, with a bigger manufacturing sector and a shift in budget revenues away from domestic sources and towards tariffs. Higher tariffs are here to stay.

Tariffs Provide Leverage on Trading Partners

In his recent Fox News interview, Bessent stressed how one use of tariffs was to exert leverage on trading partners. But this begs the question: leverage for what purpose?

Trump mentioned illegal immigration and fentanyl as reasons for the 25% tariff on Mexico and Canada and 10% on China. Yet, illegal immigration and fentanyl seem a bigger problem at the southern than the northern US border. What other motives could Trump have entertained?

Greater military integration with Canada is one possible reason. It would be consistent with Trump’s insistence Canada considers becoming the 51st state and with Secretary of State Marco Rubios announcement that foreign policy would be focused on the Western Hemisphere and aim to ‘strengthen trade ties, create partnerships to control migration, and enhance our hemisphere’s security.’ However, Trump must realize heavy handedness could prove counterproductive, which could be why he suspended the 25% tariff on Canada.

Promoting reshoring in the US over ‘friendshoring’, especially in Mexico is another possible motivation. In a recent interview, Rubio stated ‘What the Chinese are now doing is they’re creating these front companies. They’re investing in Mexican manufacturing and then backdooring – using the USMCA, the free trade agreement, to get Chinese goods into America. And so it creates this trade imbalance, and that needs to be confronted.’

EU, Denmark Next

Furthermore, Rubio’s Western Hemisphere focus suggests other regions are likely to get a tougher deal. China is most exposed with its very large bilateral surplus (Chart 3). Therefore, the 10% tariff appears more likely to get increased than negotiated away.

Of course, as Bessent mentioned during his confirmation hearing, a phase 1-type deal with China could include additional purchases of US exports and even direct investments in the US. However, this could deepen the ties between the US and China when the administration’s long-term goal is to weaken them.

Trump has announced he intends to put additional tariffs on European Union countries. Denmark could get higher tariffs than the rest of the EU due to its refusal to sell Greenland, which Trump thinks the US needs to own for national security reasons. Rubio explained, ‘The Arctic has some of the most valuable shipping lanes in the world.’ He sees a risk that ‘China will eventually try to do in Greenland what they have done at the Panama Canal and in other places, and that is install facilities that give them access to the Arctic.’

By contrast, I do not expect Taiwan or Japan, which have bilateral surpluses with the US greater than Canada, to be tariffed. They have a close defence relationship with the US and would likely agree to buy additional US exports or appreciate their currencies to pre-empt tariffs.

Bottom line, we have seen only the opening salvo of what is likely to be a pugnacious US trade policy. More tariffs threats and resolution, or not, are coming.

Market Consequences

I expect the tariffs or phase-1 type deals to add to inflation risks. The low and stable unemployment rate and a worsening external balance show the US economy is already experiencing resource pressures (Chart 4). These resources pressures imply significant pricing and wage setting power on the part of businesses and workers and, in turn, second round wage and price effects from the tariff hikes.

Even if I am overly pessimistic and the threats of tariff hikes get resolved through additional purchases of US exports, these would add to demand pressure and eventually to inflation.

Following the tariff whiplash, several FOMC members, including doves such as Goolsbee, Bostic or Dally are now calling for a longer wait-and-see period to get greater certainty on the administration’s policy intentions.

Overall, the tariff saga adds to my conviction of no 2025 Fed cuts. By contrast, markets are still pricing about 1.9 cuts.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)