Viewpoint
April 04, 2025 | 17:11
April 4, 2025
Economics
Economics
Economics
Economics
Economics
Economics
Risking Our Economic and Financial Future |
| Tariff threats have already turned into tariff reality with profound implications for the U.S. and global economic outlook. Indeed, the entire international rules-based order the U.S. helped build in the aftermath of World War II is being shaken to its core. If you think those abstract global macroeconomic concepts don’t impact you, think again. You are about to feel it to some degree, and not in a good way, in your monthly budgets, your retirement savings, and your job security. Given the global nature of these reciprocal tariffs, it will be almost impossible to avoid being impacted. |
| Economists have a word for it, stagflation, and it’s one of the most painful economic conditions a household will ever face if it’s severe enough. In fact, stagflation got so bad in the 1970s that economists invented a Misery Index that combined the inflation rate and unemployment rate to better describe the economic pain. Stagflation wasn’t kind to equity investors either. Over the entire decade of the 1970s, the S&P 500 increased only 17.2%—or an average 1.7% a year. The Federal Reserve will have a tough time coming to the rescue as it can’t fight a slowing economy without aggravating inflation and can’t deal with inflation without causing slower growth and more potential job losses. The risk of an outright recession over the next twelve months is palpable, probably near 50%, if the tariffs are left in place as they are now. We have warned our readers about the growth and inflation risk from tariffs since the November election—and even downgraded our growth outlook and increased our inflation outlook once already—based on the March tariff announcements. But with this week’s reciprocal tariffs and 25% sectoral tariff on autos now in effect, and threats of additional tariffs on pharmaceuticals, semiconductors, copper and lumber coming soon, it’s time to once again revisit our baseline U.S. forecasts. The reciprocal tariffs proved more far-reaching and severe than nearly any analyst dared anticipate. Almost no country is immune with a 10% universal baseline tariff going into effect. The tariffs were especially harsh on Asian exporters. Many countries have already threatened retaliation, so a full-blown trade war looks to be in the cards unless cooler heads can walk us back from the ledge. We estimate the weighted average tariff rate for the U.S. today is around 24%, higher than in the 1930’s Smoot-Hawley tariff era and about double what we had baked into our previous baseline forecasts. As a result, we are sharply cutting our U.S. growth outlook and increasing our inflation outlook for 2025 and 2026. We marked down our U.S. GDP growth forecast over the next two quarters to around 0.5% annualized which puts Q4/Q4 GDP growth for 2025 at an anemic 0.6%, six-tenths lower than our prior forecast (Chart 1). Below-potential growth is expected to linger into 2026, though will begin to recover modestly as the Fed cuts interest rates and inflation begins to decline from its peak. Annual core PCE inflation is expected to increase to around 4.0% by the end of the year, instead of the 3.3% previously forecast, before easing in 2026 as consumer demand softens, the labor market slackens, and services inflation moderates (Chart 2). Stagflation-like conditions will leave a visible mark on the labor market as the unemployment rate rises to 5.0% by year-end and holds near that elevated level in 2026 (Chart 3). The biggest change in U.S. tariff policy in more than 80 years is turning into a risk for our economic and financial future. |
Escalation DayThough granting Canada and Mexico a much welcomed reprieve, the White House’s new global baseline and reciprocal tariffs will have serious consequences for the global and U.S. economy. |
| On April 2, President Trump unveiled the Administration’s much-anticipated reciprocal tariff plan. The scheme has two streams. The first is a minimum 10% tariff on all trading partners, even those for which the U.S. sports a trade surplus. This is effective April 5. It fulfills the President’s request in the America First Trade Policy Memorandum, signed on Inauguration Day, to investigate establishing a “global supplementary tariff” that would be applied to all trading partners. The new levy was not given an official name, so we’ll simply refer to it as the ‘global base tariff’. The second, for a group of 57 countries/regions that contribute the most to America’s trade deficit, is instead a jurisdiction-specific tariff that runs as high as 50%. This is effective April 9. Canada and Mexico were excluded from the plan. To establish such a comprehensive tariff scheme, the President once again invoked the International Emergency Economic Powers Act (IEEPA). This was used for the first time to justify tariffs in February to establish hefty fentanyl/migration related levies on Canada and Mexico. The April 2 Executive Order said that the “lack of reciprocity in our bilateral trade relationships, disparate tariff rates and non-tariff barriers, and U.S. trading partners’ economic policies that suppress domestic wages and consumption, as indicated by large and persistent annual U.S. goods trade deficits, constitute an unusual and extraordinary threat to the national security and economy of the United States. That threat has its source in whole or substantial part outside the United States in the domestic economic policies of key trading partners and structural imbalances in the global trading system. I hereby declare a national emergency with respect to this threat.” |
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Financial markets were not expecting such a comprehensive and punitive plan, which helps explain their extreme reactions. Before the unveiling, the Administration appeared focused on reciprocal tariffs for the so-called “Dirty 15”, again, the group with the largest contributions to the trade deficit. Note that the top four contributors alone—China, European Union, Mexico, and Vietnam—account for around two-thirds of the U.S. trade shortfall. A reciprocal tariff was intended to mirror the duties and non-tariff barriers American businesses faced in foreign markets. But calculating it would be a Herculean task, even for just 15 entities, particularly under the short timeline set by the President. The crafters had to take a shortcut. How did the Administration calculate the tariff rate equivalent of the various duties and non-tariff barriers faced by U.S. businesses? Well, it didn’t. Instead, it employed a thought exercise that answers the question: For a specific country, given America’s trade deficit with it and imports from it, what is the tariff rate that would reduce imports enough to eliminate the deficit? The answer is determined by the degree to which tariffs pass through to the prices faced by final U.S. customers and the degree to which the demand for imports decreases owing to higher prices (the elasticity of demand). The Administration assumes the pass-through is 25%, so three-quarters of the tariff increase would be absorbed by narrowing profit margins of foreign exporters and U.S. importers. A higher pass-through proportion would require a lower tariff rate to eliminate the deficit (and vice versa), other things equal. The Administration assumes an elasticity of 4, meaning a 1% increase in prices will lower import demand by 4%. A lower elasticity would require a higher tariff rate to eliminate the deficit (and vice versa), all else equal. These two assumptions were used for all jurisdictions, and, when multiplied, effectively cancel out as they equal unity. The result is that the bilateral tariff rate is simply the U.S. trade deficit divided by imports from the country or region. This is not a reciprocal tariff that quantifies the duties and non-tariff barriers faced by U.S. businesses abroad, despite being touted as such. The actual ‘reciprocal tariff’ being applied to U.S. trading partners is set at half the calculated rate (see Table 1). From the get-go, the Administration said it was open to negotiating lower rates, but the global base tariff of 10% was non-negotiable. So, the horse-trading and retaliatory measures will now commence. Note that the weighted-average reciprocal tariff rate listed in Table 1 is for illustrative purposes only. This is not the effective rate because goods currently facing ‘Section 232’ or national security tariffs are not included. For all countries, steel and aluminum, along with automobiles and parts, face separate 25% tariffs. The scheme also excludes goods currently under trade investigation (copper and lumber) and those planned to be investigated (semiconductors, pharmaceuticals, energy, and select critical minerals). Importantly, the global base and reciprocal tariffs will not be stacked upon sectoral duties, including the 25% levies mentioned above and the others to follow. |
| The April 2 Executive Order says the tariffs will remain in place until the President deems progress has been made in reducing bilateral trade deficits and in resolving barriers on U.S. exports, as well as aligning “with the United States on economic and national security matters”. So, some walk-back of the tariffs is possible, though this will likely take time and tense negotiations. The flipside is that the President can also increase tariffs if countries retaliate. The European Union, which was hit with a 20% reciprocal tariff, has said it will try to negotiate lower tariffs initially, but, if unsuccessful, could counter with a “strong plan”. China, which was hit with a punishing 34% reciprocal duty on top of the 20% increase imposed since early February, has already announced plans to retaliate further with a 34% duty on some imports from the U.S. RamificationsThematically, the hefty hike in America’s average tariff rate has reduced our projection for real GDP growth and lifted our inflation call. This makes the Fed’s job more difficult, but we reckon that growth concerns will eventually dominate even more, keeping an autumn resumption of rate cuts on schedule, and on a slightly more aggressive course than previously thought. The key to these changes is the evolution of the average tariff rate. |
Our material downgrade of the economic outlook reflects the sizeable increase in the imports-weighted average tariff rate stemming from the new global baseline duty of 10% and reciprocal tariffs ranging up to 50% (on poor Lesotho). We estimate the effective baseline and reciprocal tariff at around 20% (Table 2). This raises the U.S. effective tariff rate by about 11 ppts, and along with previously announced sectoral tariffs and country-specific duties on China, Canada, and Mexico, raises the U.S. effective tariff rate by about 21 ppts since February 1 (Table 2). Since the U.S. effective tariff rate was 2.4% in 2024 (according to The Budget Lab of Yale University), the level is now around 24%, the highest in more than a century. That’s about double what we previously assumed in our economic forecast, warranting a further 0.6 ppts downgrade to our 2025 real GDP growth call to 0.6% on a Q4/Q4 basis, lowering the annual rate from 1.7% to 1.4%. Consequently, the unemployment rate could be headed to 5.0% instead of 4.5%. Meanwhile, we boosted our inflation forecast by another 0.7 ppts, with the annual CPI rate likely to peak around 4% later this year, even with weaker oil prices. Bottom Line: The President’s “Liberation Day” announcement of reciprocal tariffs provides some relief for Canada and Mexico but implies a much more challenging environment for many other countries and the U.S. economy itself. The global trade war has escalated, raising recession risks, and the outcome will critically depend on which policy response dominates: retaliation or negotiation? |