Thoughts

November 29, 2024 | 14:29

Sussing Out the U.S. Economic Impact of the Latest Tariff Threat

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

President-elect Trump didn’t waste much time in launching another tariff salvo, this time against his neighbours, which, at least for now, have free trade agreements with the U.S. But come Inauguration Day, if Canada and Mexico fail to implement measures to restrict the flow of illegal migrants and drugs into the U.S., they will be hit with a 25% tariff on the flow of all legal goods into the U.S. That wouldn’t be good for either country (as Robert and Sarah discuss in their Thoughts), but it also wouldn’t be great for U.S. businesses (which would initially pay the 25% ‘tax’) and consumers (who ultimately would bear the cost). It also wouldn’t help U.S. exporters if their products suddenly became more expensive due to a stronger dollar and possible retaliatory actions.

It’s a straightforward exercise to work out the impact on U.S. inflation of the threatened tariffs assuming all else is held equal. The three countries (China was also threatened with an additional 10% tariff) account for 42% of U.S. goods imports (15.6% Mexico, 13.5% China, 13.0% Canada, based on the most recent 12-month tally). Thus, the weighted tariff increase amounts to 8.5%. About 11% of consumer expenditures are on imported goods (according to an older San Francisco Fed study), so the direct lift for consumer prices would be 0.9%. But, as discussed in our recent Focus article, the eventual impact on inflation would be smaller due to changes arising from the tariff, such as a stronger U.S. dollar and price cuts by foreign producers. So, prices would likely rise less than 0.9%. The Budget Lab at Yale University estimates the tariffs (and retaliation) could lift U.S. consumer prices by 0.75% in 2025.

Even if the rise in inflation pales against the quadrupling that occurred in 2021 and 2022, it would raise concerns at the Fed. But these concerns would also be tempered by a weaker economy. The tariffs would apply to over $1.3 trillion of imports, or nearly 5% of GDP. In our Focus article last week, we cited three studies (from the IMF, Tax Foundation, and the Peterson Institute) that suggested a 10% across-the-board tariff on all countries, along with retaliation, could reduce U.S. real GDP by an average of 1.0% through 2026. Trump’s latest tariff threat would have a somewhat smaller impact, as the weighted tariff increase is less than 10%. But while a 0.9% reduction in real GDP likely wouldn’t pull the economy into recession, it could slice projected growth next year (of 2.2%) nearly in half. Importantly, a period of sub-potential growth would moderately raise the unemployment rate.

A higher jobless rate wouldn’t go unnoticed at the Fed, as Chair Powell recently said that the labour market is no longer a source of inflation pressure. However, under tariffs, higher unemployment would at least help keep the increase in inflation temporary. So, policymakers would likely not see the need to speed up the pace of easing. If anything, they might be more cautious and prone to pause longer in between rate cuts due to the increased uncertainty about the inflation outlook.

Some categories of imported goods, most notably motor vehicles and parts from Canada and Mexico, heavy oil (about 4 million barrels per day) and lumber from Canada, and fruits and vegetables from Mexico, could be granted exemptions from tariffs. American consumers wouldn’t be too happy paying more for new cars and homes, gasoline, and avocados, along with most other items. One research group estimates that a 25% tariff on imports from Canada and Mexico could lift U.S. vehicle prices by an average of $3,000. Any exemptions, of course, would mitigate the impact on inflation and the economy. But Americans would pay some price, either at the cash register or from job losses—which is likely our best hope of reining in the new administration’s worst instincts on protectionism.