US President Donald Trump’s aggressive use of tariff threats is rattling markets.
George Brown, senior US economist, and David Rees, head of global economics at Schroders consider the possible impact.
Global shares fell on Monday 3 February and the dollar rose following news that the US planned to apply tariffs to goods from Mexico, Canada and China, starting from Tuesday 4 February.
Later the same day, news emerged that the tariffs on Mexico and Canada would not be implemented to the original timetable but paused for one month, leading to some reversal of the market reaction.
China hit back with 10-15% tariffs on a range of US goods (starting 10 February) and an antitrust probe into Google.
The market reaction shows the difficulty for investors of assessing policies such as tariffs. Financial markets are not waiting to discover all the detail before pricing possible impacts and this is leading to increased volatility across asset classes.
Are tariffs just a negotiating tactic?
The White House said the tariffs are aimed at putting pressure on the three countries to combat illegal immigration and the flow of drugs into the US. So far, this appears to have been effective with Mexico and Canada agreeing to tighten up border security in exchange for a delay to tariffs coming into force.
We saw a similar scenario play out in January when Colombia refused entry to US military flights carrying deported migrants. The US threatened Colombia with trade tariffs and Colombia subsequently permitted entry for the aircraft and avoided the imposition of tariffs.
However, the tariffs on Mexico and Canada have been paused, not scrapped. President Trump has been using his platform, including social media, to explain the tariffs. He appears willing to accept the potential economic pain that they may cause in terms of stock market falls and higher prices for US consumers. From that perspective, investors cannot assume that tariff threats are purely a negotiating tactic.
How extensive are the proposed tariffs?
Over the weekend of 1 and 2 February, Trump issued an executive order applying tariffs of 25% to all imports from Mexico and Canada (with the exception of a 10% tariff on oil from Canada), as well as additional 10% tariff on imports from China.
During his first term, Trump’s trade war with China had minimal impact on inflation. Prices of the 11 tariff-impacted categories rose by 2.5%, which only added about 0.1% to US core CPI (consumer price index) inflation.
However, the announced tariffs on Canada and Mexico ought to have a more substantial impact, if implemented as strictly as initially suggested. One reason for this is that a much larger share of trade would be captured if Mexico and Canada were involved. These countries account for 28.3% of total US imports versus 13.6% for China.
What would be the economic impact for the US of the proposed tariffs?
The tariffs on Mexico and Canada have been paused for a month but any implementation of tariffs points towards higher inflation and lower growth for the US economy.
We outlined what we call an “Aggressive Trump” scenario in our latest economic forecasts. That scenario is predicated on broader tariffs than have been announced to date, as well as substantial deportations of migrants.
Forecasts for growth and inflation would move in the “stagflationary” direction outlined under this scenario, with the US growth outlook weakening accompanied by higher inflation, and a lower growth/lower inflation outcome for the rest of the world.
That said, the US economy is much stronger now than it was during Trump’s first term. Relatively strong demand means that firms will be better able to pass on price increases. A strong dollar and lower corporate profit margins will still take some of the hit, but probably not as much as in the past.
Tariff news sends dollar higher
The dollar strengthened again on Monday in response to the tariff threat, with other currencies weakening to offset the competitive pressure.
In addition, the balance of risks in terms of US monetary policy is tilting towards no further rate cuts this year, whereas other regions (eurozone, UK) remain in easing mode.
But the dollar is stronger than rate differentials alone imply. The discrepancy may reflect a “Trump premium” for the dollar given tariffs and fiscal uncertainty.
Could affected countries circumvent the tariffs?
China was the main focus of tariffs during President Trump’s first term. And China avoided a lot of the tariffs by rerouting goods through third party countries, including Mexico.
Obviously, rerouting goods would be much harder for Mexico and Canada given that the goods travel over land. What this means is that the impact of these tariffs, if levied, is likely to be greater this time around than in Trump’s first term.
What does this mean for China and the EU?
Trump is expected to meet with President Xi Jinping in the coming days, creating the possibility that a compromise could be reached. If not, China is likely to devalue its currency to offset the impact of tariffs, as it did in the first trade war.
The authorities will be mindful of the risk that a weaker currency exacerbates already-weak domestic sentiment. But the rapid imposition of tariffs also increases the probability of a larger fiscal stimulus to support domestic growth.
So far, tariffs have not been announced on the EU, although Trump has previously said that he intends to do so. There is a risk for EU companies that China dumps products in the EU given tariffs on Chinese exports to the US.
In the event that the conversation moves to Europe, the EU is likely to want to negotiate a deal before tariffs come into effect. Europe may seek to buy more weapons and LNG (liquified natural gas) from the US. The EU runs external surpluses (i.e. exports more than it imports) and if it were to lose US demand due to tariffs then it would be difficult to replace that with demand from elsewhere.