Tariffs, Tweets, Trade and Trump: An Update

We assess some likely costs to the United States, China, and the rest of the world from the current round of tariffs—and a potential future escalation.

In a recent interview, the President of the United States commented on an optimistic trade policy tweet he issued only moments earlier: “It seems to be having quite an impact on the market. I looked—the market was down. Now I think it's up.”¹

But as the chief executive well knows, the tweet giveth, and the tweet taketh away. After a series of social media broadsides by President Trump against China’s trade policy last week, the United States announced additional tariffs on Chinese-produced goods on May 10, sending global markets sharply lower in response. (China countered with its own tariff announcement on May 13.)

The U.S. administration is clearly weighing market reaction to its current actions, but at the same time investors are trying to absorb how far the White House will press China. While the economic impact depends on the ebb and flow of negotiations, beyond the tweets that batter markets we think the main issues are as follows:

• We believe an increase in the tariff rate to 25% on $200 billion in Chinese imports will increase inflation and slow growth in the United States by slight amounts. But imposing tariffs on the remaining roughly $300 billion in imports—something indicated as a potential follow-on move by the U.S. government—potentially will notably increase inflation and decrease growth, in our view.
• Spillover effects could make all of these developments more pernicious than simple accounting exercises. For example, non-Chinese producers could raise prices as they are shielded from Chinese competition. Alternatively, Chinese exporters are more dominant in certain products, and this will make it difficult for the firms that depend on these inputs to find cheaper alternatives.
• Much like his instinctual grasp of market timing, the U.S. president is attuned to the economic cycle. And in this respect, the timing is relatively favorable for a small trade war as U.S. employment is strong and inflation is subdued. But pressing China further may risk a more adverse reaction in markets.

Running the Numbers
Last week’s decision to boost the tariff rate on $200 billion of Chinese imports to 25% represents a 15% incremental increase. If the entire cost is passed through to U.S. consumers, this would represent only 0.2% of the $14 trillion in aggregate consumer spending (based on data from the U.S. Bureau of Economic Analysis). Limiting the impact to the pass-through only is a very stringent assumption for three reasons: trade diversion to countries not subject to tariffs is possible in some cases; tariff costs may not be fully passed on to consumers; and depreciation in China’s currency, the yuan, could offset some of the tariff impact. This last item is particularly vexing for the Trump White House as it has in the past accused other countries, such as Turkey, of circumventing tariffs through currency depreciation.  We believe Trump is likely counting on a muted impact on inflation: Estimates of the impact of the tariff increase on the personal consumption expenditure (PCE) index, an inflation benchmark monitored by the U.S. Federal Reserve (Fed), range from 0.1% to 0.3%, and are thus fairly moderate.

The latest twist in the trade policy saga likely will weigh on so-called “soft” data, but it comes at an opportune time as the economy is well-prepared to absorb a moderate shock. With regard to confidence, we think businesses’ outlook for future investment may see a negative impact from a more erratic policy environment and a further erosion of the rules-based trading system enshrined in the World Trade Organization. Manufacturing sentiment surveys are already somewhat depressed and thus incremental negative news may not be perceived as overly disappointing, in our view.

With the U.S. economy running at high levels of employment, with moderate inflation, the increase in trade tensions arrives at a time of relative strength in the business cycle. The U.S. Federal Reserve (Fed) is currently on hold in terms of potential interest-rate hikes and likely will look beyond the potential inflationary impact of the tariffs. Our belief is that the increase likely would be modest, with little direct effect on the medical care, communications, and financial services categories that have helped keep inflation below the Fed’s 2% target in recent years. However, if inflation expectations were to shift decisively lower, policymakers could decide to take action and deliver a rate cut in order to signal concern over a potential return to a disinflationary environment.

The Potential Cost of Escalation
If the U.S. government raises tariffs on the remaining roughly $300 billion of Chinese exports to 25%, the terrain would become considerably more threatening, in our view. A full pass-through of these added costs to consumers would represent an additional $75 billion, or 0.75%, hit to consumption, subject to the same caveats mentioned previously. The inflation impact would rise to about 0.4% to 0.5% of PCE.

In addition to slowing the U.S. economy, higher tariffs could lop up to a full percentage point off Chinese gross domestic product (GDP) growth, possibly bringing it below the 6% rate that Chinese policymakers consider a critical baseline, eliciting additional stimulus measures from Beijing. With China representing about one-third of world GDP growth, we think a second round of U.S.-imposed tariffs could bring about a substantial slowdown in world economic activity, with attendant spillovers to Europe and emerging markets.  Clearly, this “bilateral” trade dispute carries global implications, and governments and investors around the world will be anxiously awaiting the next developments.

¹Andrew Restuccia, Daniel Lippman, and Eliana Johnson, "Trump: Biden 2020 Reminds Me of Trump 2016," Politico, May 10, 2019.