Trump’s Tariffs Shock

Summary

• Yesterday’s tariff announcement reduced policy uncertainty but was of such magnitude that it created new economic downside risk.
• The tariffs will lift inflation, though it is uncertain by how much and for how long.
• The tariffs will likely lead to a contraction in manufacturing output and employment, with an ambiguous impact on the trade balance.
• Consumption and capex are likely to weaken due to the hit to households’ income and to profits.
• With the manufacturing sector accounting for only about 10% of GDP, a growth slowdown rather than a recession is my base case scenario.

Market Implications

• The tariffs have added downside risks to growth, and I will reassess my call for no 2025 Fed cuts following payrolls and Chair Powell’s speech tomorrow.

Massive Tariff Shock

President Trump’s tariff announcement yesterday is a long-term policy move and therefore reduces policy uncertainty. But the size of the tariff increase is so massive it will deliver a substantial negative shock to the US economy.

The tariffs, described by Trump as reciprocal, vary by country but I estimate the average effective tariff on goods imports will be about 28% or a fourteen-fold increase (Table 1 and Chart 1). The tariffs are applicable starting today.

Imported vehicles and parts, already subjected to a 25% tariff effective today, are exempted from the reciprocal tariffs and Canada and Mexico did not get tariffed above the 25% already in place.

By contrast, yesterday’s tariffs are additional to the 20% tariffs already placed on China, with total tariffs on imports from China now 54%.

Higher Inflation

The tariffs’ most immediate impact will be to raise the price of imported goods. The increase will be less than the tariff increase. Exporters, importers, wholesalers, manufacturers and retailers are likely to ‘eat up’ some of it. By contrast, our negative dollar view suggests currency appreciation will not mitigate the tariffs (Chart 1).

A key risk is second round effects (i.e., increases in prices of non-tariffed goods and services and eventually in wages). This is key to Fed easing but second round effects could take a quarter or two to appear – or not – in data.

I think second round effects are more likely than not because current US economic strength suggests businesses can pass on some of the higher costs to customers. That is also what the surge in PMI prices indices, ahead of actual tariff implementation, suggests (Chart 2).

Negative Impact on Manufacturing, Ambiguous Impact on Trade

More medium-term risks will be manufacturing production and employment. Manufacturing profits will be hit by higher costs of imported materials. Also, several countries have already implemented retaliatory measures and others are preparing to do so. The risk is that US exporters could, in turn, face higher tariffs and non-tariff barriers. This could led to a contraction in manufacturing output and employment (Chart 4).

Manufacturing employment has been gently contracting for the past three years because of high and rising productivity. A trade war induced contraction would be more pronounced.

The tariffs’ impact on the trade balance is ambiguous (Chart 5). So far, tariffs expectations have caused a surge in imports and an unprecedented widening of the deficit. With the tariff now in place, imports are likely to fall. In addition, the tariffs increase is likely to induce a further imports decline. However, with lower profitability and likely retaliation, exports are likely to fall as well.

Demand Weaknesses

Consumption represents 70% of GDP and therefore the hit to consumption from the tariffs is likely to hit growth. Goods represent 30% of consumption, so the tariffs will have a significant impact on households’ real incomes, though how big is uncertain.

It is unclear whether faster wage growth is likely to offset this cost-of-living increase. Nominal wage growth has been stable for the past year or so (Chart 7). Wage growth could be lifted if reduced immigration (i.e., labour supply) tightens the labour market but there is no sign of this yet and it would carry inflation risks if it happened.

While the Trump administration has announced $1.6tn foreign investments that could add to demand and lift wages, it is unclear whether these are additional or will materialize. Regardless, it will take years before factories are built and workers hired.

Another offset for the higher goods prices could be lower energy prices following deregulation of the energy sector and higher production, one of the administration’s key policies. However, it is unclear whether this could be achieved in a timely manner, if at all (Chart 8).

Yet another offset for the tariffs could be tax cuts, above and beyond the extension of the Trump 1.0 tax cuts (that are set to expire at end CY2025). But these would require a budget that seems unlikely to be agreed before Q3.

A ding to households real income will add to consumption weaknesses, following the recent increase in the savings rate caused by the loss of consumer confidence that in turn reflected the surge in policy uncertainty. Yesterday’s announcement has lowered policy uncertainty, but the tariff increase is so massive it could further undermine – rather than restore – consumer confidence.

Furthermore, with the hit to profits inflicted by the tariffs, non-residential investment (i.e., capex) could decrease, though the impact on growth is less pronounced than that of consumption. Capex presents only 15% of GDP and a substantial share of capex (especially IT) is taking place in the services rather than the manufacturing sector.

No Recession but Slower Growth

Based on current information, a recession is not my base case scenario. The US remains a domestic-driven economy where the manufacturing sector represents only about 10% of GDP.

Also, fiscal consolidation appears unlikely. Trump said yesterday that tax cuts should not be funded by cuts to Social Security, Medicare or Medicaid. There is growing risk of fiscal stimulus, with the Republicans apparently set on extending the Trump tax cuts without paying for them as well as providing additional tax cuts.

Meanwhile, GDP growth is likely to slow. On supply, the higher tariffs and cost of imports are likely to hit investment and could unravel the post-productivity acceleration. On demand, consumption and investment are likely to get hit, though strong private sector balance sheets suggest resiliency.

Market Consequences

Because tariffs add upside to inflation when it is already above the target, the Fed is unlikely to ease in a preventative manner.

In addition, the tariffs are likely to push employment and inflation in opposite directions. In deciding which to prioritize, as Powell recently explained, the Fed would be guided by its consensus document. It would take ‘into account the employment shortfalls and inflation deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.’

Yesterday’s tariffs have added downside risks to US growth, and I will reassess my call for no 2025 Fed cuts after payrolls and Powell’s speech tomorrow. Following yesterday’s tariff announcement, markets are now pricing about 3.5 2025 cuts.

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