Twists and Turns of Tariffs

Real economic growth in the U.S. would fall by half. A damaging recession in Canada and Mexico would emerge, making it harder for those countries to execute on Washington’s wish for more cooperation on border security. Whatever Washington’s ultimate agenda, these conditions would not produce desirable outcomes.

b) Moving ahead with 25% levies against Canada and Mexico would essentially end the U.S.-Mexico-Canada Agreement (USMCA), the biggest trade accord of the first Trump Administration. This outcome would create significant trust issues if and when the three nations begin work on a new arrangement. Treaties work best when parties to them abide by their terms.

Washington wants to amend the USMCA, not end it.

Washington would like to make amendments to the USMCA, especially in the area of domestic content requirements. Chinese facilities in Mexico have been producing components that travel north without paying tariffs; the administration would like to end this practice of “white labeling.” But an abrupt end to the agreement would not be welcome.

c) An all-out trade war in North America could be politically costly to U.S. Republicans. The Peterson Institute estimates that the full freight of tariffs would cost the average American household $1200 per year. This would function as a substantial tax increase, which would hit low-income households hardest.

Many local businesses in border states could be significantly hindered by a trade war, leading voters to consider change. Discontent with inflation was a significant polling issue for Americans last year; tariffs would keep this in the forefront and keep the blame centered on the party in power.

Republicans have to defend their narrow majority in the House in November of 2026. Poor economic outcomes will make that endeavor much more difficult.

d) The President’s ability to prosecute an expansive trade war without the consent of the Congress may be limited. The International Emergency Economic Powers Act (IEEPA) has never before been used to justify broad-based tariffs. If the new levies are put into place, some industries may seek legal redress; courts may well block them.

e) Large tariffs would likely lead to higher interest rates, as the markets and the Fed react to the new policy.

A North American trade war would be a very uncomfortable scenario for the Federal Reserve. The higher inflation and higher unemployment that would prevail would complicate the choice between easing and tightening.

Further, the Fed has avoided saying much about tariffs, as part of efforts to avoid conflict with the administration. After a policy meeting in late January, Fed Chairman Jerome Powell demurred each time he was asked about trade policy; he has cited a lack of specifics to defend a choice not to factor them into the Fed’s official forecasts. But some members of the Federal Open Market Committee have been less inhibited in their assessments, and the Board of Governors may have to follow suit.

In that event, a higher-for-longer monetary policy might be in the offing, which would almost certainly meet with disapproval from the White House. As we have written, the stage is set for increased friction between governments and central banks around the world.

Our base case continues to anticipate that negotiation will head off confrontation. If tariffs are eventually applied, we think it is more likely that they will be more modest and more targeted. If they are more severe, there is a good possibility that they won’t last that long; the pain on all sides may be too much to bear. But the risk of an adverse result has risen.

Markets were unsteady in the interval surrounding the brinksmanship, suggesting that a bad outcome has not been built into asset prices. We could see volatility resurface as we walk back to the brink at the beginning of March.

The root causes of trade deficits may be misunderstood.

2. Trade deficits are not necessarily signs of unfair practices.

It is abundantly clear that the U.S. administration views the existence of an external trade deficit as prima facie evidence of impropriety on the part of America’s trading partners. Many economists would disagree: high levels of U.S. consumption relative to other countries and the workings of global supply chains are more central to persistent current account shortfalls.

As we discussed in last week’s economic commentary, the situation with Canada is illustrative. Nearly all of the U.S. trade deficit with its northern neighbor centers on oil imports, which are gladly accepted. (The 10% tariff on energy shipments would have raised U.S. gasoline prices by up to fifteen cents per gallon; this would have increased significantly if Canada chose to reduce its shipments in retaliation.)

America’s presumption of guilt in trade matters is not playing well up north. During meetings in British Columbia this week, several of our Canadian clients shared deep disappointment about the manner in which their country has been treated. Canadians will elect a new liberal party leader in March and a new prime minister later this year: candidates who advocate a harder line with the United States are gaining favor, which may make it harder for the White House to get what it wants.

3. Protectionism will not pay for tax cuts.

There have been suggestions that revenue raised from new tariffs will be substantial. Analysis from the Committee for a Responsible Federal Budget (CRFB) indicates that a full implementation of new duties against Canada, China and Mexico would produce about $140 billion per year, a modest 2.6% increase in federal revenue. Proceeds will, however, be diminished by the impact of slower growth and any slippage in market performance.

Macro research firm Strategas suggests that the tariffs would effectively represent a 10% increase in the U.S. corporate tax rate. This will be borne disproportionately by industries subject to actions and reactions. If tariffs are more modest, or more targeted, their potential to raise revenue will be substantially limited.

And as Ryan noted in his recent article on budget reconciliation, tariff income that results from executive orders cannot (under present law) be used to offset the extension of tax cuts in a Congressional budget bill.

4. Europeans should be nervous.

Stressful trade discussions in North America are a bad omen for interaction between the U.S. and other regions. This is of particular concern to the European Union (EU).

Europe has persistent trade surpluses with the United States, it taxes digital services, and it has promoted corporate inversions that shift profits (and tax revenue) into places like Ireland. Further, several European countries are behind in their commitments to NATO defense spending.

The White House will soon turn its attention across the Atlantic, a region which is already struggling with fiscal problems and political instability. President Trump was no great fan of the European Union during his first administration, and may therefore not offer the EU the best of terms.

With so many unknowns, it is hard to support a new forecast.

5. We are not yet making changes to our forecasts to account for tariffs.

Our baseline outlook does not incorporate an all-out trade war. Our expectations have been informed by the patterns of the first Trump term: threats were frequent, negotiations were prolonged and final outcomes rarely went to extremes. The tariffs proved to be tolerable. Employment and economic output grew without interruption, while inflation rose in only limited categories. Further, the 2024 Republican Party Platform made only a passing mention of baseline tariffs, offering few specific plans or targets.

The events of last weekend challenged the assumptions underneath our forecast. The marginal increase in tariffs against China were consistent with Trump’s past actions. However, the threats against Mexico and Canada signaled a potentially more assertive posture than was evident in the first Trump term.

Trade negotiations stepped back from the brink, but another brink lies ahead.

After careful consideration, we have opted not to make alterations to our projections. There are simply too many unknowns:

• As discussed earlier, the range of potential tariffs remains very wide. Open questions remain as to what countries will be targeted, what products will be involved and how large the levies will be. Without additional clarity, it is hard to form a different foundation for the outlook.
• The effects on economic growth are hard to gauge, with some parts of the economy feeling much more pain than others. More than a quarter of vehicles sold in the U.S. would be affected, with Canada’s Automotive Parts Manufacturers’ Association warning the auto sector could “shut down within a week.” But the service sector, which accounts for the vast majority of consumption and employment, would be largely unaffected.
• The impact of tariffs on inflation is hard to simulate. The costs they introduce must be absorbed through some combination of concessions by the exporter, lower margins for the domestic reseller, and higher final prices for buyer. Only the last of these is inflationary.
  
  The exact impact on the price level will also depend on the presence of substitutes for the affected products and the ability of consumers to defer purchases. Spending on durable goods like autos and furniture are infrequent. But tariffs that touch everyday items like energy and food will have an inescapable impact.

As always, we are monitoring conditions closely, and we will make changes to our forecasts when warranted.

The volatility surrounding decision making on trade is damaging to economic activity. Measures of policy uncertainty, and mentions of it in earnings calls, have soared. But events of the past week also offer some hope that concerns often go unrealized, and that the worst of tariffs will never be put into place.

This week’s retreat from North American tariffs allowed us to regain our bearings, at least for a time. But there is every possibility that we will be thrown out of balance again before long. I’ll be ordering a neck brace, just in case.

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