Tariffs threaten recession
- gcelaya2
- 23 minutes ago
- 5 min read
Iron Maiden has an instrumental song called ‘Losfer Words’. The title probably captures what most professional economists think of the latest round of US tariffs that were unveiled by President Trump yesterday. The links below cover the FT’s excellent summary of how the tariffs were calculated. The White House paper detailing the tariffs is the second link, and the bottom link is the Guardian’s take on some of the head scratching tariff impositions on relatively remote economies, which makes an interesting read.
John Calverley, Tricio’s Chief Economist notes that President Trump’s tariffs are larger than anticipated and are likely to have a shock effect on business and consumers in the US and elsewhere. It is this shock effect which could trigger a recession: The direct impact of tariffs is not enough.
Economists estimate the direct impact by working through the tax increase on US consumers, the reduction in exports by other countries and by US exporters as other countries retaliate. There are feedback effects of course. For example, lower US growth will in itself also lower growth elsewhere and vice-versa. But initial estimates suggest that the direct impact on the US is of the order of 1% of GDP. For an economy growing 2.5% last year, this would point to a slowdown not a recession.
But business and consumers have already been spooked by the threat of tariffs, as well as by worries over government jobs and deportation threats. Trump also promises growth-positive policies such as deregulation and income tax cuts, but the positive effects of these will be backloaded. Tariffs, as well as the fear of disruption they bring, are happening now.
Shock effects are always hard to calibrate. Remember the Brexit vote with some forecasters predicting a UK recession. That forecast assumed that consumers would react to the shock by cutting back spending. But consumers didn’t cut back. Instead, they dug into savings to keep spending, apparently thinking that the effect of Brexit would be temporary. Or perhaps just that they would wait and see. Business paused briefly, and investment flatlined in following years. But they didn’t cut back. So growth continued in the UK and there was no recession.
The US personal savings rate is already low, though it went up over the last two months as consumers held back on spending. What will they do next? Shrug off a trade war? Or start expecting a recession which would be self-fulfilling?
Meanwhile US businesses also face uncertainty. As well as the higher risk of a recession, many will face higher input costs or uncertainty about exports. This could apply to service companies as well as goods producers since some of the retaliation will be against services.
Of course, Trump wants firms to produce more in the US, replacing imports. There will be some immediate scope for this for some lucky companies. Or they may raise prices at first if their foreign competitors are forced to raise theirs. New investment to raise capacity though will take time. And firms may move cautiously since, if the tariffs were reduced later on, they could find themselves with an uncompetitive plant.
Meanwhile, tariffs will raise prices, probably by about 1-1.5% in a one-off jump. Possibly slightly more if firms take the opportunity to boost margins. This will be enough to keep the Fed cautious. Don’t expect a pre-emptive Fed this time. That of course adds to the recession risk.
All this uncertainty will play out in the markets, as we already see. In a recession stocks and bond yields will go a lot lower. And the Fed will cut rates substantially, though again, probably a little sluggishly given its inflation fears. If the slump turns out just to be a dip in growth, perhaps to around 1% for a year, the decline in stocks and yields will be less and the Fed’s moves smaller.
A US recession, combined with the effects of tariffs would be enough to push the euro zone and UK back into recession. Again, there is plenty of room to cut rates.
We are not pessimistic for the long term. Tariffs are a one-off hit to inflation, growth and confidence. Of course, they also damage efficiency as well. Most estimates suggest that the US will face a permanent loss of GDP of 0.5-1%. But once the recession passes, economic growth would resume, with interest rates a lot lower. And, although tariffs will raise inflation temporarily, a recession is likely to bring wages and inflation back down to the 2% target, or below, very quickly.
From a market point of view, the other Iron Maiden classic ‘Run to the Hills’ may be what market practitioners are doing now – and in fact have been doing since February. Buy bonds, sell stocks, get ready for a recession. We have written about this in previous blogs, Focus reports and our regular publications. How long can this ‘flight to safety’ last? Previous adjustments show that markets tend to overshoot when trying to price in risks. In this case, we may think that the US 10 yr. note yield could turn below 4% for a move towards 3.6%, the low from last summer. But an extension to 3.3%/3.0% could be seen if the economy really starts to soften (not just a slowdown or soft recession). Stocks? The S&P 500 already fell over -10% from the February all-time highs. A -20% knock would put the index just below 5,000. A lot of the long-term chart analysis that we looked at for our latest Monthly Insights put risk down to the 4,000 area – a near -35% fall from the all-time high.
We are not that bearish – yet. Much depends on known unknowns – we don’t know how long the tariffs will be in place. We don’t know how other countries will respond, and how the US will respond the their response etc. Long-term effects are also important. Is the old NAFTA attempt at getting Canada, Mexico and the US working together well and truly dead? This would put decades of supply chain and sourcing deals and plans into the rubbish heap and upend key industries for some time. How will the US ‘getting tougher’ with trading partners play out in other political arenas?
There will be many who will be hoping that the US will retract the majority of the tariffs if other countries make concessions or if the fallout to the stock markets (and political future of the Republican party in the midterms next year) gets headlines.
The words from President Ronald Reagan from 1987 should be remembered – targeted tariffs may be used in order to get concessions from trading partners. But a widespread trade war has negative consequences.
“You see, at first, when someone says, ``Let's impose tariffs on foreign imports,'' it looks like they're doing the patriotic thing by protecting American products and jobs. And sometimes for a short while it works -- but only for a short time. What eventually occurs is: First, homegrown industries start relying on government protection in the form of high tariffs. They stop competing and stop making the innovative management and technological changes they need to succeed in world markets. And then, while all this is going on, something even worse occurs. High tariffs inevitably lead to retaliation by foreign countries and the triggering of fierce trade wars. The result is more and more tariffs, higher and higher trade barriers, and less and less competition. So, soon, because of the prices made artificially high by tariffs that subsidize inefficiency and poor management, people stop buying. Then the worst happens: Markets shrink and collapse; businesses and industries shut down; and millions of people lose their jobs.
The memory of all this occurring back in the thirties made me determined when I came to Washington to spare the American people the protectionist legislation that destroys prosperity.”