14 Feb 2025
February 2025, From the Field - By Blerina Uruçi
Trade wars do not produce winners.
Key Insights
The new U.S. administration, led by Donald Trump in his second term as president, plans to impose sweeping new tariffs on some of the U.S.’s key trading partners. As yet, it is unclear whether widespread tariffs will become a reality or are more a threat designed to rebalance trading relationships and gain negotiating power on other issues (the recent decision to freeze tariffs on Canada and Mexico for 30 days while leaving in place those on China did not resolve this question). But let’s be clear: an extensive round of tariffs will damage global trade, with manufacturing hit particularly hard. Trade wars ultimately hurt businesses and consumers in all countries involved.
Some of the arguments used to justify tariffs are rooted in the decline of U.S. manufacturing. Free trade has hollowed out the U.S.’s manufacturing base, with inevitable consequences for jobs, national security and a loss of expertise in some areas. At the same time, some of the U.S.’s largest trading partners have employed industrial practices designed to give them a competitive advantage in certain industries. So while new tariffs from the U.S. would be highly unlikely to have a positive economic impact, they may have some justification from a political perspective.
Politics aside, however, the prospect of a new round of tariffs has tossed an extra variable into the global economic outlook. Without the uncertainty related to tariffs, the growth picture appears mixed but not unduly alarming: The U.S. seems set for another year of solid growth, China has provided some stimulus to support its economy, and although Europe may suffer a slowdown in the first half of the year, the European Central Bank is well positioned to respond swiftly with rate cuts. A recovery in Europe in the second half of the year is highly plausible, while long‑term structural developments, including the push toward renewable energy and “friendshoring,” should provide further support for the global economy.
Potential impacts of new tariffs on trade
Depending on their severity, new tariffs could undermine this relatively benign outlook. As with any other tax hike, an increase in tariffs is a demand shock. It reduces overall income in the economy (known as the income effect) and distorts demand by reducing the consumption of certain goods while increasing the consumption of others (the substitution effect), resulting in inefficient production and consumption patterns. Overall, the economy loses.
Tariffs also cause uncertainty over future spending. If a European firm plans to spend USD 1 billion building a factory to export goods to the U.S., it will want to know under which terms it will be allowed to trade with American customers. When there is any doubt over these terms, it makes sense to defer the investment until the conditions for trade have been clarified. In a sense, economic uncertainty works in a similar way to an interest rate hike: Firms delay lumpy consumption and capital expenditure and postpone hiring.
Why tariffs are bad for global growth
The imposition of tariffs not only affects the behavior of corporations and households, it also requires a response from governments. For example, if the U.S. imposed a tariff that reduced its consumption of foreign‑produced widgets, the rest of the world would experience a negative demand shock. A negative demand shock increases the output gap in the rest of the world and leaves it with excess labor and production capacity.
When the output gap increases, a free market and open economy adjusts in two ways: First, inflation slows due to softer demand and interest rates decline as a result; second, the exchange rate depreciates, which enhances international competitiveness and boosts external demand. With lower rates and a cheaper exchange rate, an equilibrium framework dictates that the output gap is closed through a combination of net softer external demand and stronger domestic demand.
However, despite a widespread perception that tariffs are inflationary, the evidence for this is unclear. By definition, inflation is a persistent increase in the pace at which prices are adjusted. By contrast, a tariff is a onetime increase in price level—not a sustained shift in the rate of inflation. Tariffs may turn inflationary if they raise inflation expectations, particularly during periods when inflation is already high and the economy is operating close to full capacity. However, there is little evidence to suggest that the imposition of a onetime tariff on goods has a long‑term inflationary impact.
The U.S. economy has little to gain from tariffs
So how would the U.S. and global economies be affected by high tariffs? Well, one of the main arguments for imposing tariffs would be to try to narrow the U.S. trade deficit, which is almost double the size it was when Trump first became president eight years ago. However, I do not believe this will be easily achievable. For one thing, there is a very good reason why the U.S. imports goods from around the world: It would be inefficient and much more expensive to produce everything the U.S. needs domestically.
What’s more, the relative strength of the U.S. economy compared with the rest of the world means that Americans can afford to buy more foreign goods. If Trump succeeds in his promise to further raise U.S. income, the trade deficit could go even higher as Americans will buy even more goods from overseas.
Who is most at risk from potential U.S. trade tariffs?
(Fig. 1) Canada, Mexico, and small manufacturing hubs could be hit hard
As of December 31, 2023.
Sources: World Bank, International Monetary Fund, Organisation for Economic Co‑operation and Development. Analysis by T. Rowe Price.
Although U.S. producers in protected industries stand to benefit from tariffs, this will not necessarily have a net positive effect on the U.S. economy as a whole. The benefits that these producers receive (higher prices and sales) will come at the expense of U.S. consumers.
Which countries outside the U.S. will be hit hardest? There are three main factors to consider here: first, that countries heavily reliant on manufacturing will suffer because of reduced capital expenditure; second, that countries heavily dependent on exports will be hit by reduced global trade; and third, that countries that can use monetary policy to mitigate an external demand shock will be able to protect their economies better than those that cannot.
Given all of this, those most at risk include the small open manufacturing hubs of Asia and Central and Eastern Europe. Countries with particularly heavy exposure to the U.S., such as Mexico and Canada, could also be hit hard (Figure 1).
Stronger dollar, weaker equity markets
One of the most immediate asset class implications of new tariffs from the U.S. would be a stronger U.S. dollar (because tariffs on imports invariably appreciate the home currency). In response, foreign central banks will ease policy, resulting in currency depreciation. Even countries whose central banks cannot cut rates will likely see their currencies depreciate as foreign exchange markets tend to chase growth.
In bond markets, tariff expectations have so far led to higher inflation expectations and an increase in long‑end yields. But if the focus were to shift to negative impact of tariffs on growth, the yield curve would likely steepen as reduced growth expectations would raise expectations of rate cuts. It is worth noting that the policy response in the U.S. will initially diverge from that in the rest of the world: As higher tariffs will only affect the price level and are unlikely to result in sustained inflation, the U.S. Federal Reserve (Fed) is likely to remain cautious as it monitors the impact on inflation expectations. The continued resilience of U.S. growth also means the Fed is under less pressure to ease rates.
However, I do not believe that the Fed will end up tightening monetary policy as a result of new tariffs: Tariffs likely will hit the American consumer much as a value‑added tax (VAT) hike would. While tariffs may drive up domestic demand for some U.S.‑produced goods and services, a VAT increase is a tightening of the fiscal stance and it is rare for a fiscal tightening to lead to further economic overheating.
As the imposition of tariffs takes a toll on economic growth, growth‑sensitive assets such as equities are likely to suffer in a regime that relies on the widespread use of tariffs. Further, the increase in economic uncertainty that is associated with tariffs is likely to raise the risk premium investors demand to hold risky assets—an additional headwind to equities. Should the equity market fall in response to the imposition of tariffs, financial conditions will tighten, raising the likelihood of central banks being forced to ease policy. However, some of these effects on U.S. businesses could be offset by a favorable budget deal and further corporate tax cuts, which in my view are reflected in the market pricing. The sequencing of fiscal and trade policy implementation will be important to ensure that the positive growth trajectory in the U.S. continues.
We should remind ourselves again that while negotiations over tariffs are still taking place, any discussion of their ultimate impact is somewhat speculative. A key outstanding question is whether new U.S. tariffs would result in a large‑scale global trade war. If the U.S. targeted a few smaller, select countries, a global trade war would almost certainly be avoided. However, if the Trump administration decided to pick a trade fight with the entire world or the largest economies in the rest of the world (China and the EU), large‑scale tariffs on U.S. exports would be far more likely and the ramifications would be felt globally.
The prospect of a global trade war that benefits nobody should factor into the U.S.’s thinking on tariffs. Whether it does remains to be seen.
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