On 2 April, the Trump administration announced sweeping tariffs that were more aggressive than many had expected. Then on 9 April, the administration announced a 90-day pause on most of the new country-specific “reciprocal tariffs.” However, tit-for-tat retaliation has further escalated tariffs on U.S. imports from China, and vice versa.
President Donald Trump has consistently emphasized the trade deficit as a measure of unfair practices by other countries that disadvantage the U.S. Many investors, businesses, and world leaders were surprised by the administration’s apparent willingness to tolerate the ensuing near-term economic disruption and market volatility in pursuit of long-term changes to global trade dynamics. The 90-day pause creates some time for de-escalation and negotiation, but the overall direction remains clear: higher tariffs are likely here to stay.
If the tariff plan moves forward as initially announced, the near-term outcome will likely be stagflationary domestically and contractionary globally. Yet, the Federal Reserve may face challenges in aggressively cutting interest rates due to an uncomfortably large upward domestic price adjustment. These policies are likely to be deflationary for the rest of the world, resulting in fewer constraints on central banks outside the U.S. to cut rates.
Tariff announcements to date
On 2 April, Trump announced a comprehensive “reciprocal tariff” plan aimed at addressing perceived trade imbalances and unfair practices by U.S. trading partners. The plan has two main components: 1) a baseline universal 10% tariff on all imports into the U.S., and 2) additional country-specific tariffs on imports from 57 countries with significant trade deficits.
Then, on 9 April, Trump announced a 90-day pause on country-specific tariffs for those countries that did not announce retaliatory tariffs – so, most of them. But China, which responded with its own set of tariffs (34% on all goods imported from the U.S.) over the weekend, is the notable exception: As of this writing, the U.S. now imposes a 125% tariff on Chinese imports.
For Mexico and Canada, the 25% tariffs announced in early March on an estimated 50%–60% of goods imported from these countries remain in effect, and will likely be a focus of future negotiations around the U.S.–Mexico–Canada Agreement (USMCA). And many specific goods – such as steel, aluminum, passenger vehicles, lumber, pharmaceuticals, and semiconductors – are either already subject to U.S. tariffs or will be soon, according to the administration.
Overall, we estimate that if fully implemented, the tariffs announced since early February, plus the additional product tariffs that we expect will be announced soon, would together raise the effective average tariff rate on U.S. imports to levels that exceed those of the 1930s. And even if some tariffs are dialed back, it’s still very likely that the overall rate will remain dramatically higher than anything seen in decades.
Tariff outlook, near term and longer term
We believe the scope, scale, and longevity of U.S. tariffs hinge on three overarching goals of the Trump administration:
- Reducing the U.S. trade deficit and rebalancing global trade
- Lowering U.S. federal fiscal deficits
- Reversing the decades-long decline in labor’s share of income
In addition to potentially raising revenue for the Treasury, the administration likely sees tariffs as a strategy to inflict enough pain on the current global trading system to compel structural changes in other economies, aiming to reduce or eliminate subsidies – whether implicit or explicit – to their manufacturing sectors and boost U.S. exports. China remains a central focus of U.S. trade policy, and in any negotiations, the administration will likely seek assurances that Chinese manufacturers can no longer use investments in “connector countries” (to use an IMF term) as a way around the U.S. direct tariffs on China.
The U.S. approach with Canada and Mexico could be informative: Imports that don’t comply with the USMCA’s strict rules of origin – such as those from Chinese-owned factories built after Trump’s first term – face 25% tariffs.
The administration has signaled its willingness to negotiate on trade and tariffs. Indeed, the 90-day reprieve followed a week in which many countries approached the U.S. to “negotiate a solution,” as President Trump wrote. Deals with economies where the U.S. runs a trade surplus, including the U.K. and Australia, are likely to be more easily negotiated, as well as deals with Japan and Argentina. However, tariffs targeting countries with serial trade deficits with the U.S., such as China and various countries in Europe (Germany, Ireland, Italy, Switzerland, France, Austria, and others), and Asia (Vietnam, Taiwan, South Korea, Thailand, Indonesia, and others) could be more difficult to negotiate away: These countries may need to implement structural policy and economic changes in order to reduce their serial trade deficits. Negotiations and deals are possible, but could be much more challenging for these countries.
Overall, we expect that elevated tariffs on China, a 10% baseline tariff (with the exclusions mentioned above), and various product tariffs are here to stay. Select country-specific reciprocal tariffs, even if they are implemented following the 90-day pause, could still be negotiated down.
What are the economic effects?
Assuming all of these tariffs are implemented as initially announced, we would expect the U.S. economy to experience recession and higher inflation, at least in the short run. Even if the 90-day reprieve turns into a longer stint, we still think U.S. recession odds are 50/50. Higher tariffs on U.S. imports raise costs for domestic consumers and businesses and reduce real disposable incomes and profit margins. Retaliatory measures will further damp U.S. exports. Since the tariffs are applied to producer and consumer goods alike, they will tend to make investment (as well as consumption) more expensive. In that sense, these tariffs are similar to a large and inefficiently applied consumption tax, where the only near-term winner is the U.S. government deficit.
Elevated uncertainty is likely an additional drag on growth, as businesses face little cost in delaying hiring and investment decisions. Services industries aren’t likely to be immune. Although goods industries make up only around 10% of U.S. real GDP growth (according to the Bureau of Economic Analysis), engineering a sudden stop in trade will affect services industries built around commerce: retail and wholesale trade, logistics and warehousing, trade financing, etc.
As a rule of thumb, we estimate that each 1 ppt increase in the average effective tariff rate shaves off about 0.1 ppt of growth while adding a similar amount to inflation. This calculation excludes potential offsets from federal government measures, such as remitting the additional tariff revenues back into the economy via lower income tax rates, higher subsidies, or lump sum payments.
Based on this rule of thumb, the estimated 30-ppt increase in effective U.S. tariffs (if it is implemented and maintained) likely will send the U.S. into a recession and raise near-term inflation dramatically. Given our previous baseline expectation of 2% growth and 2.5% inflation, we now expect U.S. growth to contract in the second half of the year. We estimate core CPI inflation could accelerate to 4.5%, though headline inflation may be around 1 ppt lower if the 20% decline in global energy prices (as of this writing) is sustained. While these estimates are highly variable, it’s clear the U.S. economy hasn’t seen a shock like this since the 1920s and 1930s.
A key issue in projecting the economic effects of tariff policies is understanding who is the more flexible party. Focusing on U.S. trade with China, for example, the Trump administration has made the argument that China is less flexible, and as a result will pay more of the cost of the tariff, with high tariffs benefiting the U.S. on net. The administration has indicated its view that China has few other markets to sell goods at scale, whereas the U.S. has a lot of flexibility to buy goods from domestic manufacturers and other markets.
Our view is that over the long term, assuming substantial investment in U.S. manufacturing, this might become the case. However, in the short run, we would argue the opposite is true. With many products, Chinese producers operate with monopoly-like power, because they have used implicit subsidies generated from government policies and lower labor costs to largely outcompete U.S. manufacturing. Witness the decades-long reduction in U.S. manufacturing’s share of GDP coinciding with Chinese import competition. As a result, U.S. consumers today have less ability to switch to domestic supply.
Implications for the Fed
All of this puts the Fed in a tough position. Unlike 2018 and 2019, when Fed officials preemptively cut the fed funds rate in response to trade-policy-related uncertainty, we suspect they will be slower to react to economic weakness this time. The scale and scope of the tariffs (enacted and proposed) suggest a much more extensive price pass-through, which we estimate could raise inflation materially above the Fed’s 2% target (as measured by headline PCE). This outlook could constrain the Fed’s ability to cut the policy rate – barring a more material increase in the unemployment rate. Furthermore, because this is a policy-induced downturn, the Fed must also grapple with the potential for policies to be rolled back at any time – as indeed happened on 9 April.
The Fed will have to assess recession risks and inflationary risks in real time, taking into account the knock-on impacts to financial markets and consumer and business expectations. Financial conditions have tightened dramatically in the U.S. recently. However, inflation expectations surveys have also moved higher.
As a baseline scenario, we believe the Fed will likely respond in the second half of this year by cutting the policy rate as U.S. unemployment likely mounts. Ahead of that, the Fed potentially could use unconventional tools to stabilize the U.S. Treasury market, not dissimilar from the Bank of England’s bond-buying program in response to the 2022 disorderly rise in gilt yields.
Since any Fed rate cuts this year would contradict traditional Taylor rules, which could prescribe hikes amid inflation pressures, Fed communications would likely emphasize the temporary nature of the above-target inflation while highlighting that demand effects and rising unemployment tend to be more enduring.
In light of tariff revenues, should we expect larger tax cuts?
Possibly. Over the weekend, the Senate passed a budget bill, which made the Tax Cuts and Jobs Act permanent and included additional tax cuts costing $1.5 trillion over 10 years. Unlike a similar bill passed by the House earlier this year, which included $1.5 trillion in government spending cuts, the Senate version doesn’t include steep cuts to Medicaid and other programs. It’s possible that the additional tax cuts could be front-loaded, but the roughly $150 billion per year average yearly cost from the Senate bill would offset only a portion of the additional estimated $500 billion to $600 billion per year raised by tariffs. In other words, if the Senate version of the bill becomes law, then the more aggressive tax cuts could offset some of the tariff-related “tax hike,” but likely not all of it. The net effect of income tax cuts and subsidies plus tariffs amounts to a very inefficiently applied consumer or value-added tax.
Overall, we believe the U.S. fiscal impulse is likely to be negative near-term, but longer-term deficits are generally still a concern. Since tariffs can be unilaterally reduced by a president anytime, the risk of this mix is skewed toward higher deficits over time.
Investment takeaways
As we discuss in our latest Cyclical Outlook, fixed income may provide a source of stability amid market volatility. Elevated uncertainty is likely to challenge the U.S. equity outperformance of recent years. Despite the recent volatility and repricing in U.S. Treasury and other fixed income markets, there is still a strong case to diversify away from highly priced U.S. equities into a broader mix of global, high quality bonds that offer attractive starting yields and a more favorable risk-adjusted profile.
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