Gauging the impact of tariffs under Trump

The following is an extract from our latest CIO update.

One of the biggest policy differences between the presidential candidates is trade; at stake is the speed of deglobalisation.

The Democrats will probably maintain a tough stance on China, with existing tariffs unlikely to be rolled back. The Republican agenda appears more radical. Trump has not been specific, but at times during the campaign he has mentioned a 60% rate on all goods from China and a 10% rate on all other imports. Reducing the overall trade deficit and boosting US manufacturing seems to be the goal.

The initial rounds of tariffs on China have almost halved the bilateral goods deficit as a share of GDP. But there has been little impact on the overall goods trade deficit as it has mainly encouraged trade diversion. Some of this is Chinese-manufactured goods being transferred and then sold out of third countries such as Vietnam, but it also represents new supply chains developing in countries more aligned with US interests (friendshoring in Mexico).

Four key questions

Economists rarely agree, but there is near-uniform opinion that tariffs raise inflation and reduce growth – and the risk of recession grows non-linearly as the scope and magnitude of tariffs broadens. There are many questions to resolve, including:

1. The level of tariffs to be introduced and on what products is not currently clear. There would likely be intense lobbying from retailers to prevent tariffs. In the event of a Trump administration, we would watch the key appointments carefully. These would likely influence the policy stance. In the first wave, the Trump administration was careful to avoid China tariffs directly on consumer goods where the inflation impact and squeeze on real consumption would likely be larger
2. There are various protectionist mechanisms available to the president that do not require Congressional approval. But the extent of the authority is not clear. Our view is using the various trade and tariffs acts legitimately would merely slow rather than prevent the imposition of tariffs
3. How will the rest of the world respond? The greater the retaliation, the bigger the hit to US exports and global growth
4. Finally, how would financial markets react? Trump has implied one reason for tariffs is to force other countries to revalue their exchange rates. But economic theory suggests the dollar is likely to appreciate in response to US tariffs. The dollar could also get a bid due to its perceived safe-haven quality, despite US policy being the cause of the hit to global growth. In our view, the equity market and credit reaction to aggressive use of tariffs would likely be negative, even if the tariff revenue is used to partly fund an extension of the tax cuts due to expire over the next two years

The impact on US rates is ambiguous and would also hinge on the wider market reaction. A strong dollar would mitigate the upward pressure on US prices from tariffs, while a global trade war would have a chilling effect on business investment and inflation.

Consensus seems to be that any tariff increases would be targeted and limited. If Trump follows through on the campaign rhetoric mentioned above, this raises the effective tariff rate on US imports to near 20%. In this scenario, we calculate the level of US core inflation could rise around 200 basis points. This would complicate the ability of the US Federal Reserve to respond to the shock, though if it triggers a global recession, which is plausible, the central bank would likely cut rates.

The above is an extract from our latest CIO update.