An Early Look at the Implications of Tariffs and a Trade War

After the trade war’s opening salvoes, tensions seem set to last for some time.

Over the weekend, the Trump administration announced it was imposing a 25% tariff on goods imported from Canada and Mexico as well as a 10% tariff on goods from China. It’s a clear signal that a new trade war has begun. We can’t know at this stage the specifics of what will come next (a back and forth continues), but in our view trade tensions will be persistent: there’s more to come.

Canada, Mexico and China are the largest trading partners of the US, collectively accounting for roughly 40% of all US imports: more than $1 trillion in goods per year. The companies and individuals who import goods pay the tariffs—the measures recently announced are a tax on those goods.

How Will the New Tariffs Affect the US Economy?

As with any tax, the latest salvo of tariffs will likely reduce growth by taking money from consumers’ pockets. But tariffs are more complicated to assess than typical tax policies. For most imported goods, businesses will pay the tax at the border; households don’t pay it directly.

The question then becomes whether that higher cost to businesses is passed through to consumers through higher prices—and if so, how much of a hit it will be. During the 2018 trade war, almost all of the higher tariffs eventually fed through to higher consumer prices, and we expect the same to be true this time. The result: households will face higher prices for imported goods.

From our perspective, tariffs will boost prices but aren’t truly “inflationary” from a policymaking perspective. When the Federal Reserve sets monetary policy, it focuses on sustained price pressures—not one-off adjustments to the price level. Tariffs more closely resemble the one-off variety.

To put it another way, the Fed can’t change the price impact of tariffs by moving interest rates. As a result, we don’t think it’s likely that trade policy will significantly affect the central bank’s policy trajectory. We believe the Fed will assess the balance between slower growth and higher prices rather than responding preemptively to changes in global trade patterns. 

Supply Chains, Return Salvoes and Unsettled Markets

Consequences will likely extend beyond the direct impact of tariffs. Even if higher import costs are passed through to consumers, domestic industries may still be forced to rejigger supply chains—a potentially costly and burdensome process.

There’s also a high probability that other countries impose reciprocal tariffs on US goods; Canada has already indicated its intent to do so. Those return salvoes would impose costs on US exporters. And if the 2018 experience is a useful guide, financial markets may not be happy. We expect the US dollar to strengthen, as it has since tariffs were identified as a clear result of the presidential election. While the trend in equity markets isn’t as clear, at the very least we expect higher volatility as the back and forth of the trade war continues in the coming months.

Trade-War Costs More Manageable for the US

Taking everything into account, we see the costs of the trade war as manageable from the US perspective. Its economy enters this period of heightened uncertainty in a strong, stable position. Growth, the labor market and inflation have all been steady for the past several months and the general state of the economy is balanced. This should make it resilient even as the policy framework changes.

Also, the US is not a particularly trade-sensitive economy. A common way to measure this sensitivity is through trade openness: the total of imports plus exports divided by gross domestic product. The US, with a relatively low trade-openness rate of 27% (Display), seems less likely to suffer dire consequences from a trade war than other countries where trade is a much higher share of the overall economy. 

What happens next is unclear. The range of potential outcomes is quite wide; tariffs could be limited in scope and duration, or they could escalate quickly and dramatically in the weeks and months ahead. The only certainty when it comes to the policy environment so far this year has been uncertainty, and that seems likely to be a feature for the foreseeable future.