How high could tariffs go?

Paul Diggle

Hello and welcome to Macro Bytes the economics and politics podcast from Aberdeen with me, Paul Diggle.

Luke Bartholomew

And me, Luke Bartholomew.

Paul Diggle

Today we're going to be talking about the tariffs. I should say, before we get started, that we're speaking on the afternoon of the 8th of April. It's a very fast-moving situation at the moment. It has been an incredible time in financial markets and in economics, watching the tariff announcements from the Trump administration and the enormous fallout that has been roiling global financial markets.

On the pod today, Luke and I are going to take stock of some of these announcements, talk about where policy will go from here, how things might get better, how things could, on the other hand, continue to get substantially worse.

But I thought I'd start, Luke, by briefly outlining the tariff regime. So, the Trump administration announced a set of ‘reciprocal’ tariffs which impose a global baseline 10% tariff on all trading partners, and then an additional amount above and beyond that 10% floor, which reflects the size of countries’ goods trade deficits with the US. And specifically, there was a formula used -- it is the size of the goods trade deficit divided by the amount of goods exports that a country sends to the US, divided by two, and with a floor at 10%. And this number is what Trump thinks of as the tariffs and the unfair trading practice the other economies are imposing on the US. Now there is, I think it's fair to say, Luke, quite little foundation in economics for that sort of calculation. It really does play to Trump's long-held beliefs that trade deficits represent how much another country is ripping off the US in international trade terms, but it doesn't really say anything about the size of tariffs, or indeed, non-tariff barriers that other countries impose on the US. And nor, I think, are there especially good reason to think that they will work to lower bilateral deficits in quite the way that Trump hopes they will. Or might turn out to be a little bit of a game of ‘whack-a-mole’ where goods are redirected through lower-tariff economies, bilateral deficits for where they are currently largest, but then increase elsewhere. I think economists would normally think that overall trade deficit the US is running with the rest of the world wouldn't respond to tariffs. Instead, it reflects deeper structural, patterns in the US economy about the balance between investment and saving, the trade deficit, the current account, is a reflection of the capital account. It could be, however, that actually this does in the end change the size of the US deficit. But because it increases domestic saving, it lowers domestic consumption. It makes the US less attractive place for foreign capital to flow to. So, by closing the capital account, surplus, in turn, closes the current account deficit.

Luke Bartholomew

Well, maybe that's a good point to think about some of the likely economic consequences of these tariffs. And I think the first thing to say is, this is clearly a stagflationary shock, in the sense that it pushes up on inflation and down on growth at the same time. But then beyond that, being precise about the exact magnitudes of that shock is extremely difficult. It depends in part on how financial markets behave, how consumers and firms respond to the tariffs. But there are some rough rules of thumb that we can use to get a first guess kind of estimate, and the kind of tariff increase pushed through by these announcements. So, a roughly 20 percentage point increase in the average effective US tariff rate, probably be associated with something like a 2% increase to the US price level and a 1 to 2% hit to US GDP growth. Now those estimates, the reason they're so rough and ready is in part because they are estimated in rather more stable economic climates, because they're broadly linear in how they assume the economy responds. But it's quite plausible that the economy could be hitting some non-linearities in this kind of environment, that the economy starts to behave in quite unpredictable ways, or more extreme ways. And you could imagine that on the growth front, because confidence is so badly hit that it starts to feed on itself, and moreover, not only is this a big tariff increase, but also the level of uncertainty remains extremely high. It's quite possible that tariffs are reduced from here; they go higher from here. And in that context, it's very difficult for firms, consumers to take big economic decisions. So, hiring [and] investment plans can all snarl up. So that would hit growth worse. And on the inflation front, you could easily see inflation expectations start to ratchet higher. And then that becomes a self-fulfilling loop of higher inflation. So, I think it's fair to say that those estimates are probably biased on the small side -- that the inflation shock could be bigger and the negative hit to growth could be bigger as well. But then if you start to map that kind of shock to the US economy as it currently stands, the underlying rate of growth in the US now is probably around one-and-a-half to 2%. So, hit by that kind of shock that I was just describing, and it's very easy to get growth down to around zero, or indeed, into a negative number. So, we think the chances of a US recession are about 50/50 at this point. And then maybe, just very quickly, on the medium to long run consequences of these shocks. In the medium term, perhaps it's a little bit more controversial to call this an inflationary shock. Certainly it pushes the price level up in the near term, but maybe it doesn't have this inflationary effect of price level increasing again and again and again. In fact, maybe the very weak growth environment I was describing there is such that actually it's very difficult for inflation pressures to pick up and over time it actually ends up being a disinflationary shock. I think that largely depends on how inflation expectations evolve. And then in the long run, picking up on some of what you were saying, Paul, about the US being a less attractive place to invest, a less attractive place for capital returns. I think the strong consensus in the economic literature, the overwhelming consensus, it's fair to say, is that trade restrictions like this reduce efficiency, reduce how well allocated capital and labour is across the economy, reduces the gains from trade, and means that potential growth is lower, returns on investment, therefore, you'd expect to be lower. And that means that the US is just a less attractive place to invest over the long run.

Paul Diggle

I think there is an important offset to talk a little bit about, though, which is that tariff revenue could be recycled into the US economy through tax cuts. So, we usually think, one model of tariffs are they are tax increases. But Trump may partly be thinking of them as a revenue raiser to fund tax cuts certain to extend the Trump era, initial set of the ‘Trump 1.0’ set of tax cuts, and perhaps to go further on parts of corporate tax or personal taxation. So, the administration has talked about raising up to $6 trillion in revenue over a decade from the tariffs. I suspect that is a substantial overestimate, not least because it doesn't do dynamic scoring -- so it doesn't take account of what is, as you've said, Luke, very likely to be a negative growth shock from these, that will in turn weigh on tariff revenue. But they certainly, I think, are thinking about them as creating fiscal headroom to fund tax cuts. A big problem from the perspective of the global open, global trading system is that the more that the administration is incorporating tariff revenue into a reconciliation bill to fund tax cuts, the more permanent tariff increases are because then they become a standing part of the US fiscal architecture. A bit like much earlier in the Republic, from Alexander Hamilton onwards, where tariffs were an important revenue source. And then it is much harder to bring them lower again. For now, Congress is a little bit more hesitant to do a very large tax-cutting package of the magnitude that Trump has talked about, and the various bills working their way through the House and the Senate involve much smaller tax cuts than, I think, that Trump has talked about and is hoping for. And I suspect, ultimately, that we're going to get.

Luke Bartholomew

So, you talked, Paul, there about the fiscal policy side of this. But I guess the other question is how does monetary policy respond? And I think the normal thing to do for economists when faced with this kind of shock, this stagflationary shock as I was describing it, is to wring our hands and say, how difficult it is for central banks in that environment. What a nasty trade-off that creates [because] inflation going up, but also presumably unemployment going up as well, given the weak growth environment. So the Fed's mandate pushing in different directions. And that's the kind of way in which Fed policymakers themselves have been describing the shock. For example, Fed Chair Jay Powell gave a speech a couple of days after the tariffs were announced, and having seen a large extent of the market moves, and continue to strike a line which was broadly that keeping inflation expectations well anchored was the key thing that the Fed was focused on. And, you know, that was, I think, a relatively hawkish line compared to what the market was expecting, because the market is not wringing its hands at all and talking about a difficult trade off. Its judgment is very clear -- that this is a growth shock, or at least it's the growth shock that will dominate, and that the Fed will need to more aggressively ease policy. Now, I would caution, Paul, that it's not quite the same for the Fed as it might have been in the trade war in say 2017/2018, and other shocks of this nature where central banks sometimes like to look through the inflationary consequences and, indeed, focus on those growth aspects. And that's because inflation expectations are just less well anchored this time. And there is this bias, well-known bias amongst policymakers, to always be fighting the last war, as it were. And of course, inflation did get out of hand in 2022 coming out of the pandemic and to the extent to which policymakers are scarred by that experience, and they feel that need to rebuild their credibility around that, perhaps that would mean that they need to be a little bit more aggressive in keeping inflation expectations control and to be less accommodative. But that said, I think a clear path is opening up for a number of Fed rate cuts this year. And if we get a recession kind of scenario, then interest rates have a long way to fall -- you know, 400 basis points, a four-percentage point fall, in the fed funds rate is very easy to envisage in that kind of scenario. That's a perfectly normal response to a US recession. So yes, the market is pricing a fair bit at easing. But if it's a recession, it can go an awful lot further.

Paul Diggle

And investors often think about the Fed as offering a put option on financial markets. That is to say that, if things got really bad in markets, the Fed would step in to ease interest rates, to provide liquidity if market dysfunction became an issue. The other sort of ‘put’ that people talk about at this juncture is [the] ‘Trump put’, that Trump himself may pivot away from these tariffs, may enter negotiations with other countries, may in time turn to, as I've said, the tax cuts or deregulation aspects, which, you know, only a few months ago really excited risk markets. I think that is one important way in which it gets better from here. I suspect there's still a substantial expectation in markets that actually the increase in the US average tax rate to 22%, where we sit roughly now, will gradually grind lower as a variety of deals are being done. And even in the past day or two, we've heard headlines about Japan sending a delegation to Washington to start entering talks. They may well be offering concessions, particularly around the automotive sector, lowering tariffs on US cars into Japan, promising or perhaps engineering a way in which they can buy much more US cars. We've had South Korea apparently looking to do an early deal. Vietnam, Mexico seems quite open to a deal. So, a range of countries, that are going to Trump and starting to offer concessions. Netanyahu, Israeli prime minister, has talked about trying to fully close the bilateral deficit that, Israel, the US is running with Israel. I would be somewhat cautious about quite how much the US tariff rate is going to come down in response to those deals, partly because signals from the administration on their openness to do deals continue to be somewhat mixed. On the one hand, Trump secretary, Treasury secretary, Bessent has said in certain settings that countries are lining up to do deals. They're going to get deals out of these countries. On the other hand, those same people, other members of the administration have said this is a wholesale remaking of the global trading system. It is about protecting strategic industries. It's about raising tariff revenue. It's about decoupling from China. And there isn't really that considerable scope to bring tariffs down again. Perhaps a useful mental model to have is that the 10% global baseline tariff is a revenue raiser, and it's therefore hard to see that going. The sector-specific tariffs on steel, aluminium, cars, in time, perhaps semiconductors, pharmaceuticals. Those are about protecting strategically and politically important industries, nurturing them within the US and it's hard to see those tariffs coming down. But maybe the reciprocal element, reflecting the size of bilateral trade deficits, that's the bit that's open to negotiation. But again, the caveat to that, in turn, is that it will be quite hard for countries to bring down those bilateral deficits, or perhaps those that do might be offset by an increase in deficits elsewhere.

Luke Bartholomew

So, I think picking up on pieces of that, Paul, that perhaps one of the most surprising things this year has been just how much risk tolerance the Trump administration seems to have, around this strategy that it's pursuing. Or how willing it is to take market pain. That the administration does seem to be committed to this idea that it's inflicting short-term pain for some supposed long-term gain, and that's a strategy that it doesn't plan on deviating from anytime soon. That the so-called ‘Trump put’ is deeply out of the money -- the market needs to fall a long way before the administration feels it needs to back away from this strategy. And moreover, political pressure is not particularly high at the moment. The mid-term elections are still a long way away. Trump support amongst the base is extremely strong. Now some of that could change as the effects of tariffs come through, but for now, those pressures don't seem to be particularly pressing. And so, as much as you are painting their pull away in which this could get better, there is also a very plausible path where the tariff level gets higher in the near term, at least partly because some of the tariffs that we expect that Trump's talked about haven't actually come through yet. There are still further sector-specific tariffs on things like pharmaceuticals that are likely to be announced. And then perhaps more substantively, there is the possibility of a ratcheting up of tariffs through rounds of tit-for-tat retaliation. So, China, for example, announced retaliatory tariffs on the US last week, to which Trump then responded, saying he would add a further 50% tariffs on China unless they back down from their retaliation, to which China, in due course, could indeed further retaliate. And there are other trading partners, the EU, maybe Canada, who also look like they could be pursuing a retaliatory strategy, not quite to the same extent, but yes, there are other trade partners who could be pushing up their tariffs, which in turn generates further rounds of tariff increases. And then I guess, an even bigger breakdown in global trade that could occur on the back of that is not just the way in which tariffs between the US and its trading partners increase, but a much more balkanized global trading system evolves because, non-U.S. trade finds itself facing far greater tariffs. And the reason for that could be that in the scramble to find markets that are now being closed off in the US, exporters look to sell to other countries, which in turn interpret that as aggressive dumping in their markets, and so put up tariffs. And so, you know, EU, Chinese tariffs end up having to increase as a consequence. Other major trading blocs increase their tariffs. And so, what you end up with is just much, much higher levels of tariffs across the board and not just on a bilateral US and its trading partner basis. And yeah, that would lead to a significant breakdown in the global trading order as we've known it.

Paul Diggle

And while we're pushing the envelope on downside scenarios, perhaps it's worth pulling the camera back further, casting on it further, and thinking about what else is now possible, thinkable, in the worst-case scenarios. Given that Trump has increased tariff rates well beyond market, most people's baseline in line with, what we had long thought of, as a kind of, a risk scenario. And beyond full on global trade war, as you were describing there, Luke, another one, it strikes me, is now a risk, is more of a financial plumbing type of crisis that would in time necessitate the central bank, the Fed and other central banks, to step in and provide a substantial amount of liquidity support. So, one way in which you might motivate this is that sharp sell offs in a variety of US assets, in particular, which have been quite highly owned by parts of the financial system. Certain particular products leveraged on, on the US tech sector could see even more selling pressure if that starts to unwind in a systematic way. You get a liquidity squeeze in the market. You get selling not just of things that have gone down, but also have much higher quality holdings of bonds, for example. Then you get a larger scales for a liquidity crunch. And I think financial regulators will be starting to think about these kind of downside scenarios. The Fed will be thinking about it carefully and looking for that point at which financial market functioning itself is broken down. To be clear, we're not there and we may never get there, but it is at least a plausible downside at this point. That would then, I think, necessitate quite a large monetary policy offset.

Luke Bartholomew

And then one thing that could really gum up financial market plumbing, both in the short term, in the way that you were describing there Paul, but also over a long run, requiring, frankly, completely different financial market plumbing. And that is on the table, or at least in the ether, it seems, is the US imposing effectively a tax on investments in US Treasurys. And we talked about this proposal, briefly, in our Mar-a-Lago accord episode. And it's an idea that's associated with Stephen Miran. He wrote a paper that we talked about on that podcast. And the idea, and it relates to what you were talking about at the start there Paul that, in one sense, current account deficits can be seen as the mirror image of capital account surpluses. And so, one way that you can squeeze down on your trade deficit, if that's what you want to do, is try and reduce inward investment flows to the US. And one way you might do that is to effectively tax Treasurys to make them more expensive to buy and hold. I mean, technically, Miran calls them ‘user charges’, I think, to avoid the language of tax, but that's effectively what they are. And we said in that podcast that you should be careful what you wish for in that respect, because obviously the risk of off-putting investment that much is US government financing costs increase significantly. But the other thing that could happen is, yeah, it's a breakdown of the current architecture, the financial plumbing, because Treasurys are just an integral part of how repo markets work, money markets work, what banks have on their balance sheet. And to suddenly make all those assets significantly less valuable by putting a tax on them, would just lead to a breakdown in the current system of financial market intermediation.

Paul Diggle

If the US is taxing foreign holdings of Treasurys, then you would presumably get quite large selling of Treasurys in that world, as you were saying, Luke. Another related risk then, that people have long worried about, is systematic dumping of Treasurys holdings by China, in particular. So, for context, China is a large holder of US Treasurys. It holds perhaps 3% or so of the stock of Treasurys, more of the free float, the amount that's not held by the central bank in the US. It's the second largest foreign holder. It's still a long, long way below domestic holdings of Treasurys. And the thought is that it could, sort of, weaponize this holding -- selling, putting upward pressure on US funding costs. And that would be a financial escalation of the trade war, considerable escalation. Now obviously, this would be in many ways self-defeating or self-harming. But you know what? Tariff retaliation is also a form of self-harm, some countries engage in it anyway because international relations are a repeated game -- you need to use punishment and deterrence because you keep playing this game over multi-year period. And then continuing to take the thought experiment further still. Another risk, I think that is out there, again of pretty low probability but certainly a risk, is the end of central-banking independence. So Trump, of course, during its first term and so far into a second term, has been very vocal in verbally, rhetorically intervening in monetary policy, telling Chair Jerome Powell that he should be cutting interest rates into this. Powell’s recent communication, as you've been saying, Luke, has been much more resistant to that. Obviously, towing a much more independent line, pointing out the inflationary consequences of high tariffs as well as the negative growth impact, saying that it's not obvious what the Fed should be doing. And Trump will, of course, just keep stepping up his rhetorical pressure on the Fed. But I think it's more serious legal escalations that are most worrying. So, Trump will, you know, almost certainly be replacing Powell as Fed chair when his term is up early next year. But the worry is that he fires Chair Powell in the meantime. And the statutes say that he cannot do that except ‘for cause’. But ‘for cause’ is a rather loosely defined legal term. People point to this recent firing of several FTC commissioners by Trump ‘for cause’, which is now being litigated in the courts, and that this could set a precedent about the president's ability to fire and replace the Fed chair as well. And then, even more fundamentally, it could be that we are at the start of the end of central bank independence, that independent inflation-targeting central banks were a feature of the post-Cold War ‘end of history’ liberal economic order, was appropriate and politically acceptable to delegate monetary policy to non-politicians, to technocrats, in a very different world of more stable inflation, fewer geopolitical threats, less need for monetary policy to play a big fiscal role. But that we are just not in that world anymore. And needless to say, like these other tail-risk scenarios we've been talking about, it would be an enormous upheaval of the global financial system.

Luke Bartholomew

All right. Well, I think that is all we have time for this week. I have no doubt that we will come back to talk about tariffs. But dare I say, I rather hope that some of those more extreme events we were discussing, the, Paul, are not things that we have to address frequently or regularly or anytime soon. But look, as ever, please, do forgive me if I ask you to once again, like, subscribe to the podcast if you have not already done so, and then all that remains is for me to thank you all for listening. So, thank you very much and speak again soon.

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