U.S. tariffs and their impact on growth and inflation

A primary goal of the new administration is to narrow the United States’ trade and current account deficits, which have continued to grow.

To that end, the administration has already imposed or is planning an array of trade taxes, including levies on the United States' three largest trading partners, Canada, Mexico and China. Together, those three nations run a trade surplus of $593.5 billion with the U.S. In addition, the administration has imposed 25% tariffs on all steel and aluminum products entering the U.S.

The administration has four primary goals with tariffs:

• Revenues: Increase government receipts to help offset the cost of a domestic tax cut.
• Fair trade: Focus on reciprocal tariffs.
• Leverage: Gain negotiating power with specific economies.
• Protection: Nurture infant industries in technology and biosciences, and protect mature industries like aluminum and steel.

With the exception of raising revenues, those primary objectives in the near term will result in notably reduced growth, modestly higher inflation and slowing productivity. They will also have an adverse impact on consumer and corporate confidence. 

Our view on tariffs is that they should be treated as a value-added tax when it comes to inflation. That is, they should be seen as a one-time shock that is largely passed through to consumers, with foreign exchange markets absorbing some of the impact and importers paying for a small portion in the form of lower profit margins.

A key point on inflation is the difference between a level effect, which is a one-time increase in prices, and an inflation impact, which is the passing through of costs that raises prices on a sustained basis.

Understanding that dynamic is key to ascertaining how it will affect monetary policy.

If the tariffs end up being a one-time shock, the Federal Reserve will tend to look through them and not change its rate policy.

But if there are more rounds of trade taxes and inflation expectations increase, then the Fed would most likely raise rates to keep inflation expectations in check. In that case, businesses would spend less on productivity-enhancing equipment and slow hiring.

Already, the Fed’s preferred gauge of inflation expectations, known as the U.S. five-year breakeven, had risen to 2.5% on March 20 from the cyclical low of 1.88% in September.

What’s more, with growth slowing, we expect more volatility across asset markets and the business sector to take a more cautious approach to hiring and investment. These conditions will prevail at least until the new policies can be understood.

But the impact is already being felt. Firms are pulling forward orders of industrial supplies and consumers have eased up on their spending after a strong holiday season. Those factors pose a risk of a much slower pace of growth in the first quarter.

While it is too early to quantify the tariffs’ overall impact, a rough estimate implies a 0.5% to 0.75% drag on growth this year and a one-time 0.6% increase in prices.

The per-household cost of the trade taxes will range from $1,000 to $2,000, depending on the final status and any exemptions granted. There is currently no exemption on food imports.

The takeaway

This story, though, still needs to play out. There is ample room for a deal with Canada and Mexico, for example, as well as an opportunity to carve out exemptions that were typical during the first Trump administration. For now, though, we see this new round of trade taxes as the source of a late-cycle slowdown in growth and a bump in inflation.