The economic impact of US tariff hikes

Stephen Stanley | April 4, 2025

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

President Trump declared April 2 Liberation Day.  The next day the S&P 500 dropped around 5% and the dollar was whacked. Financial markets rendered their initial verdict, and it was not favorable.  The announced tariffs were substantially higher than anticipated and expected to do serious economic damage.  Despite the inflationary implications of the tariffs, fed funds futures immediately added about 20 bp of easing for 2025, suggesting the Fed will cut rates sooner and more often than previously expected.  The economic impact, the response by trade partners and the Fed. It’s all on the table.

President Trump’s View of Tariffs

I think we have to start by acknowledging that President Trump has an unconventional set of beliefs related to tariffs.  He sees tariffs as quite stimulative for the economy.  There are a few economists who think tariffs are good for growth, some of whom work in his Administration.  However, the overwhelming consensus among economists, including myself, is that tariffs damage the economy.  They are a tax, so this is a tax increase.  The prevailing view is that tariffs should be thought of as a negative supply shock, akin to a sharp rise in oil prices.  A negative supply shock reduces economic growth and at the same time pushes up inflation (which is why it presents such a difficult situation for the Fed – more on that later).

Based on yesterday’s speech, President Trump is clearly convinced that higher tariffs will boost U.S. economic growth.  In fact, he offered a brief take on U.S. economic history in which tariffs were a primary driver of the economy in the 19^th century.  He even argued that the Smoot-Hawley tariffs in the 1930s should have boosted the economy but simply came to late to revive an economy already headed toward depression.  In contrast, I would identify with the consensus view that the Smoot-Hawley tariffs were disastrous for the global economy.  While they clearly did not cause the 1929 stock market crash (the law was passed in 1930), the global trade war that ensued turned what might otherwise have been a bad recession into a global depression.

If the consensus view is correct, then the economic fallout from President Trump’s reciprocal tariffs could be considerably worse than he anticipates.  In that event, it will be interesting to see whether and how quickly he accepts that his view was incorrect and seeks to shift direction.

An economic analysis of tariffs

In his speech, Trump characterized the international trade environment as a battle between U.S. producers and foreign producers.  In his view, governments around the world have unfairly restrained the ability of U.S. producers to export into their markets while supporting their producers in ways that unfairly advantaged them relative to U.S. companies.  Thus, Trump seeks to level the playing field with tariffs.

Listening to his perspective, it is hard to argue with many of his points.  It is true that many countries have exploited the current global trading framework, offering their domestic manufacturers extensive subsidies to compete globally, while at the same time protecting their domestic markets from foreign competition via tariffs as well as a variety of non-tariff restrictions (like arbitrary safety rules, for example).  Furthermore, some countries are arguably outright cheating in a systematic fashion, stealing intellectual property and otherwise breaking rules that have not been rigorously enforced.  I suspect that most American voters are generally sympathetic to many of these arguments.

However, his framework ignores two key facts.  First, economists going back centuries to David Ricardo have emphasized the concept of comparative advantage.  The idea is that a country, even if it can produce everything more cheaply than a trading partner, should focus on the products for which it has the largest comparative advantage.  Resources are limited, so the most efficient alignment is that each country should do what it does best relative to everyone else.

To use a simple example, I may be able to grill a better hamburger on my backyard grill than McDonald’s, but if my greatest comparative advantage is making economic forecasts, then I may be better off to craft and sell my economic forecasts instead of grilling.  Even if I could make a tastier burger (and more cheaply), I may be better off sticking to Economics and then spending a fraction of my wages on a Big Mac if my comparative advantage as an Economist is larger.  Ricardo wrote that each country should focus its activity on what it does best, as defined by its largest comparative advantage.

In contrast, President Trump sees a bilateral trade deficit as prima facie evidence of unfair trade practices by the surplus nation.  While there may in fact be unfair trade practices in some cases, a trade deficit in and of itself does not prove that.  Perhaps someone should ask the President how he would explain the U.S.’s massive trade surplus in technology services.  He would undoubtedly note that the U.S. has the best technology companies, and their services are superior to others’.  The same may be true on the other side for goods.  Perhaps due to easy access to key raw materials or a ready supply of cheap, skilled labor, some countries hold a comparative advantage in certain products that the U.S. would be best off accepting rather than fighting.  I would hazard a guess that no matter how high Trump pushes tariffs, there are certain products that will likely never be economical to produce mostly domestically (think about products like sneakers or T-shirts).  That being said, as noted above, I would acknowledge that while some trade imbalances are natural, others are being driven by artificial trade barriers.

There is another way to think about global trade.  Rather than Trump’s view that U.S. producers and foreign producers are in a death struggle for global market share, we can narrow our focus to the U.S. market.  In this instance, the “battle” is not between U.S. and foreign producers but between U.S. producers and U.S. consumers.  Walk down any aisle of your local Wal-Mart or Target, and you are likely to find piles of imported products made at extremely low cost in China and other foreign markets.  American consumers have benefited immensely from the cheapness, even quality-adjusted, of these goods.  In fact, even if an exporter is unfairly subsidizing their exporters and “dumping” their goods in our market, arguably the U.S. consumer still benefits.  From an economic standpoint, the macro question is whether the (relatively small) benefit to consumers of these cheap products multiplied by 350 million Americans outweighs the concentrated losses for those U.S. producers who are run out of business and the workers, perhaps in the thousands, thrown out of work in the process.

It may be that the “right” answer for the economy is to accept the cheap goods because the benefit across all consumers outweighs the losses incurred by producers and workers.  In that case, the government arguably has an obligation to retrain the workers and otherwise try to cushion the blow for the fraction of people adversely affected.  I suspect that President Trump would say that we have done a poor job of that, and he would not be entirely wrong.  Even so, that would be an argument for better retraining, not across-the-board tariffs.  In any case, President Trump is a political leader, not an economist, and his perspective may constitute a compelling political argument, even if the economics are unconventional.

The other consideration for the economy is how a protected U.S. manufacturing sector would evolve.  If we go back to the 1960s and early 1970s, a time when the domestic automakers had a stranglehold on the U.S. market, the product array available to U.S. consumers was limited and vehicles were generally viewed as expensive and poorly made.  It was the discipline of stiff international competition that forced the Big Three to get their acts together and become more efficient.  This dynamic has been repeated across the world in a variety of industries.  Where governments insulate their domestic industries from competition with tariffs and other trade barriers, the domestic firms tend to jack up prices and pocket the extra profit while becoming less efficient, exactly as Economics textbooks would suggest.  Great if you are a U.S. automaker or auto worker, not so much if you are a consumer.

April 2 tariffs

In the run-up to Wednesday’s announcement, there were scores of news stories detailing the deliberations at the White House.  The impression given all along was that the Administration was conducting sophisticated analysis to quantify the tariffs needed to even the playing field for each country.  In the end, the White House published a list of reciprocal tariffs being applied that varied widely across countries, but it is not entirely clear whether there was a precise formula or if officials simply eyeballed it.  We have been told that individual country levels were determined based on a handful of factors: the size of the bilateral trade imbalance, tariffs, non-tariff barriers, VAT taxes, currency manipulation, etc.

The baseline is a 10% tariff applied across the board.  This compares to the average trade-weighted U.S. tariff last year of about 2½%.  Some countries have tariffs on U.S. goods that are well below 10% and do not engage in the distorting practices that Trump decried, so a 10% baseline appears to betray the concept of “reciprocal” tariffs.  There was no explicit effort in the White House fact sheet to explain why every country would see at least 10% tariffs.  In any case, the 10% tariffs will be imposed on everyone, starting Saturday.

For those countries accused of cheating in one way or another, tariffs will be higher.  The U.S. is imposing “discounted” reciprocal tariffs that amount to half of what the Administration calculated that each country charges the U.S. (including such things as currency manipulation and non-tariff trade barriers).  Quantifying these other factors introduces immense discretion into the process.  So, while the precision of tariff percentages suggests a rigorous analytical exercise, the reality is that the Administration has offered a black box that cannot be reverse engineered unless or until more information is made public.  The higher individualized tariff rates will take effect April 9.

This discretion extends to what comes next.  Truly “reciprocal” tariffs would presumably rise and fall automatically as other countries either retaliate or offer concessions.  However, the fact sheet states that “these tariffs will remain in effect until such a time as President Trump determines that the threat posed by the trade deficit and underlying nonreciprocal treatment is satisfied, resolved, or mitigated.”  So, any deals will have to be actively negotiated.  If some country, say India, which faces a 26% reciprocal tariff, decides tomorrow to eliminate all tariffs and non-tariff barriers on U.S. goods, the wording suggests that Trump would have to sign off before there would be any change in U.S. tariffs on Indian goods.  In other words, there is no automatic lowering of tariffs.  Conversely, if another country, say China, which faces a punishing 54% tariff (34% reciprocal plus the 20% already in place due to fentanyl), retaliates, Trump could ratchet up reciprocal tariffs further, but that would not occur automatically.

The reciprocal tariffs do not apply to a subset of goods, mainly those already targeted by Section 232 tariffs, such as steel and aluminum.  And autos.  Tariffs of 25% are being imposed on finished autos immediately, with a 25% tariff on imported auto parts scheduled to take effect in a month.  There are many critical questions about how this will interact with the USMCA.  The tariffs that have been imposed already on Canada and Mexico are not being applied to USMCA-compliant products—those with sufficient domestic content.  It seems that the auto tariffs may be applied universally.  A Stellantis assembly plant situated just across the border in Canada is shutting down for two weeks to assess the impact of tariffs, so the USMCA-compliant escape hatch, at least for the moment, may be at risk.

Tariff arithmetic

Rough calculations suggest that the average tariff rate is rising by about 20 percentage points from 2½% to the low-to-mid 20%’s.  If we focus on the 10 largest importers based on the 2024 trade figures and include the additional 20% already applied to China, the average tariff rate is more like 32%.  So, this announcement amounts to a massive increase in tariff rates.

Merchandise imports represent about 11% of GDP.  So, if we do a quick static set of back-of-the-envelope calculations, a 20% average price increase on all goods imports would boost the CPI by 2.2 percentage points.  If we assume that the tariffs are only 80% passed through (suppliers would absorb some of the costs, consumers would buy fewer imported goods, etc.), the price impact would by about 1.8 percentage points.  In theory, this would be a one-time price hike, so inflation over the next year would jump from around 2¾% to 4½% but would immediately recede back to the prior pace once the impacts were all in place.

Several Fed officials have recently noted that they are not willing to simply assume that the price effects will be strictly temporary.  One can imagine a world where firms gain pricing power and inflation accelerates more persistently.  Or, alternatively, we could see a series of retaliatory tariff hikes that creates a much longer period over which tariffs are driving prices higher.

Projecting growth impacts is much trickier.  One way to think about the fallout is to note that a 20% tariff hike on $3.3 trillion worth of imported goods would lead to a $660 billion increase in costs for consumers and businesses.  Put differently, the standard of living, what can be purchased, would drop by that amount.  Again, in reality, businesses and consumers would engage in all sorts of behavior to substitute for imports or evade the tariffs.  But the static view would be that such a hit to household and business budgets could slash around 2 percentage points off of what growth would otherwise be.  So, perhaps if real GDP growth was going to be 2% in 2025 otherwise, it would be close to zero.  In theory, growth would return to the underlying trend once tariffs reached their new level and stabilized.

In reality, the situation is far more complicated.  President Trump would presumably tell us that companies would build new factories in the U.S., generating jobs and adding to output.  That is undoubtedly true, but it would take quite a long time to come to fruition, probably several years, well beyond the relevant timeframe for financial market participants and Fed officials.  Conversely, as noted above, domestic industries might see lower productivity growth if they were less subject to the pressures of international competition, which would, over time, dampen economic growth.

What next?

This section is far more important than the prior one.  The world is not just going to sit still, generating the static impacts drawn up above.  Rather, economic entities will innovate and adjust, and the political landscape will evolve in ways that will determine next steps.

I continue to maintain two mitigating points that suggest a far less dire situation than the numbers just above would suggest.  First, I believe that President Trump and the majority of his team view tariffs as a negotiating tool.  The end game is to get to a “fairer” global trading landscape.  I admit that there are some in the Administration that would be happy to slap tariffs on and leave them in place indefinitely.  Talk of raising trillions of dollars in revenues sounds awfully nice – until you consider how much the ensuing reduction in economic activity would cut tax receipts and boost social spending.  However, I perceive that as a minority view within President Trump’s team.  So, I am assuming that after the initial round of bluster, including undoubtedly some retaliatory steps by some of the U.S.’s trading partners, deals will be struck, and tariff levels will come down for many countries.

As an aside, I was encouraged at the margin by President Trump’s tone yesterday.  He did not point fingers or villainize trading partners.  In fact, he said several times that he did not blame them for taking advantage and even admitted that he would probably have done the same thing.  This tone should, at the margin, make it easier to establish negotiations to bring tariffs down.  He did not sound to me like someone who intends to close off deals to lower tariffs.

Second, I believe that President Trump’s overarching priority is a strong U.S. economy.  As explained above, he thinks that his tariff actions will boost the economy.  If he is wrong about that, as I anticipate, then I am willing to bet that he will quickly begin looking for an off-ramp.  Striking deals in that context would be a perfect solution, as Trump can spin every bilateral deal as a win for the U.S. (and for him politically).  This might be a bold prediction, but I think that the majority of the tariffs announced on Wednesday will be gone within six months.  Am I sure about that?  Not at all.  But that is my baseline.

FOMC response

So, how will the Fed react to all of this news and volatility?  An adverse supply shock, such as this, is the worst of all worlds for the Fed because it results in slower growth and simultaneously higher inflation.  The Fed cannot fight both of those developments at the same time.  So, policymakers will wait and see, carefully weighing the risks on both sides of the dual mandate.

There are additional complications for the Fed in the current circumstances.  Fed policy typically impacts the economy with a significant lag.  I would argue that the underlying economic fundamentals are pretty solid, but President Trump’s tariff policies are going to create a big negative shock to growth and an upward boost to inflation.  But all of that could literally disappear with a snap of Trump’s fingers.  Would Fed officials want to race to, for example, cut rates in response to economic weakness when that softness could literally disappear overnight?  Also, the Fed will, as always, do what the economy calls for, but it would presumably be distasteful for the Committee to seek to lessen the blow from Trump’s policies, which, perversely, would make it less likely that he would be forced to relent and unwind the tariffs.

On the inflation side, as noted above, several officials have recently indicated that they are not willing to simply cross their fingers and assume that the inflationary impetus from tariffs will be “transitory.”  This suggests that the FOMC could be in wait-and-see mode for a while, as it will take months for the inflation wave to make its way through the economy.  As an example, auto dealers tend to hold 60 to 90 days’ worth of inventories at any point in time, so they may not begin to sell newly-tariffed vehicles until the summer.  Thus, for this industry, it could be four to six months before policymakers will be in a position to conclude whether the price hikes set off by tariffs are going to subside.

Thus, my bottom line is that the markets are pricing in too much easing and too soon.  I think the chances of a rate cut as soon as June are remote.  For a while, my call has been two quarter-point cuts this year – in June and September.  For now, I am simply going to maintain the call for 2025 but move the timing back three months and pencil in rate cuts in September and December.

However, to be clear, I see the range of outcomes for the Fed as extraordinarily wide.  I could easily see the Fed hamstrung by uncertainty for much of the remainder of the year, especially if we have two big tariff shocks this year, putting them on in April and then taking most of them off later.  Or, we may have dozens of small tariff ripples that are just enough to obscure the underlying economic picture and keep the FOMC paralyzed.  While this must seem like a remote possibility to financial market participants today, I still believe that by 2026, the full array of Trump Administration policies is going to be net-positive for economic growth, with tax cuts and regulatory relief outweighing whatever is left of higher tariffs by then.  Thus, if the Fed does not lower rates in 2025, it may not happen at all for the foreseeable future.

Conversely, if our worst fears with regard to tariffs comes to fruition, then the Fed will probably do what they usually do when the economy is weak – cut rates at a frenzied pace.  If the economy slides into recession, I would not be surprised at all if the FOMC slashes the policy rate by 200 BPs in a six-month period.  This is far from my baseline, but I do not rule it out entirely.

So, the range of outcomes is wide, and I suspect the opinions of market participants is equally varied.  This should add up to active markets, with investors on edge as news headlines continue to roil the economic and inflation outlooks.  Certainly, all of my current forecasts are written in pencil, not permanent ink.