The Big Idea
Background on tariffs
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The impact of tariffs on economic activity and inflation has been slow in coming this year, but it feels like crunch time is finally here. The US appears to be negotiating furiously ahead of the August 1 deadline, reaching several deals over the past week, and a template is beginning to become clear for many of the remaining dominoes to fall into place. This allows for some very rough calculations of the possible impact of tariffs on economic activity and prices.
Trade flows and deal progress
Merchandise imports in 2024 totaled $3.26 trillion, a little more than 11% of GDP. Meanwhile, goods exports totaled just above $2 trillion last year, a little over 7% of GDP.
Among the top 10 countries importing into the US, the administration has already struck deals with the UK (#10) and Vietnam (#6) (Exhibit 1). On July 22, the US announced a tentative agreement with Japan (#5). On Wednesday, news reports indicated that the US and EU, the #1 trading partner when considered as a bloc, were close to a framework for a pact.
Exhibit 1: Merchandise imports in 2024
Source: Census Bureau.
China has always been on a separate track. The administration’s original plan was to keep China at arm’s length, craft deals with everyone else, and then gang up on China and force them to restructure their economy away from such a heavy export emphasis. That blueprint never got very far, and, after imposing massive tariffs on China in April, the US was forced to relent and cut a deal with China in May. Now, the China talks are entirely separate. Treasury Secretary Scott Bessent noted a few days ago that the US and China have reached a good understanding, and he thinks that another 90-day extension is likely after the current deal lapses on August 12.
With the Vietnam agreement and several smaller deals with Indonesia and the Philippines, a template seems to be forming for the Asia region. At various times of late, the US was said to be close to completing pacts with South Korea, Taiwan and India.
That would leave the US’s neighbors, Canada and Mexico. The latest news from up north is that Prime Minister Mark Carney has grown less optimistic that a deal can be achieved by August 1. Meanwhile, Mexico President Claudia Sheinbaum has been relentlessly optimistic that the US and Mexico would reach a deal. It is worth noting that most trade with Canada and Mexico is exempt from tariffs due to the USMCA, which needs to be renegotiated before it expires next year.
Deal Template
The April 9 pullback from Liberation Day set reciprocal tariffs at a default level of 10% for everyone but China. My expectation has been that the Administration would seek to maintain tariffs of at least 10%, even after reaching agreements with various trading partners. Recent news suggests that the magic number may be closer to 15%. Japan agreed to a 15% baseline, while the EU is said to have signed off on a 15% baseline tariff. Since tariffs on EU goods had been nearly 5% prior to this year and the April 9 reciprocal levies were on top of that, a new 15% tariff would essentially lock in the status quo since April.
The shift from 10% to 15% as a baseline is not as dramatic as it may appear at first glance. The reason is that the original 10% reciprocal tariffs were layered on top of existing tariffs, while the 15% tariff rate (or different levels for others) agreed upon in the Japan deal is an all-in figure.
Well over half of imports from Mexico and Canada get USMCA treatment. If we exclude that portion, perhaps worth about $600 billion in 2024, goods imports were around $2.7 trillion. If we assume that the average tariff on that $2.7 trillion will be 15%, up from less than 5% before this year, the overall price tag of the new tariffs would be on the order of $300 billion to $400 billion annually. Before this year, the US was collecting close to $50 billion per year in tariffs.
Tariff arithmetic
The magnitude of tariffs impacts several aspects of the economic outlook. First, tariff revenues for the federal government will at the margin improve the fiscal outlook. In May and in June, the federal government collected between $25 and $30 billion per month in customs receipts, up from less than $10 billion per month a year ago. Of course, and this is part of the rationale for tariffs in the first place, putting a 15% tax on imported goods will presumably result in fewer imports, which will, in turn, limit the revenue windfall. I am assuming that tariff hikes will bring in something like $150 billion to $200 billion per year over the next few fiscal years. That is a huge amount of money, but, sadly, in the context of annual deficits in the vicinity of $2 trillion, it will only be of limited benefit for the troubling fiscal outlook.
Of course, like any tax increase, someone will have to pay for it. Administration officials insist that foreign producers will pay the entire tab. While this is possible, and may be accurate in a few specific cases, it is doubtful that US consumers will escape any hit. Let’s assume arbitrarily that half of the tariff tab falls on the shoulders of consumers. Based on the arithmetic above, the result would be a loss of purchasing power of about $100 billion for US households, a small but noticeable hit. Nominal consumer spending in the US runs at about $20 trillion per year, so $100 billion represents one-half of one percentage point. Enough to be noticed, but not so large as to send the consumer into a tailspin.
Translating the arithmetic to inflation, $270 billion in goods imports represents about 1.3% of consumer spending. If tariffs go from between 2% and 3% on average to an average of 15% and consumers end up bearing half of the cost, then consumer prices would rise by about eight tenths of a percentage point (1.3% of consumer spending times a 6% price hike).
In reality, the hit to purchasing power and the bump to inflation would be less than the figures derived above, since the tariffs apply to the wholesale value of imports, not their retail sticker price. At the same time, based on empirical evidence of past instances of tariff increases, consumers would be fortunate if they only bear half of the burden. So, there are certainly risks on either side of these estimates, but they do at least provide a general sense of the magnitude of the looming impact on economic activity and prices.
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