As Trump’s policy choices emerge we can start to make more sense of the consequences. The short-term effect – an economic slowdown – looks set to be different from the long-term effect – over-strong demand. That said, there are still many uncertainties both about the scale of tariffs and the eventual outcome for the budget deficit.
Trump’s policies are contradictory which, with his erratic style, is creating moderate uncertainty in the US economy and high uncertainty elsewhere. Briefly, he wants to:
Extend the 2017 income tax cuts and make further cuts including on tips, social security payments and overtime.
Reduce the Federal corporate tax rate from 21% to 20% or lower
Cut government spending
Balance the budget
Use tariffs to raise revenues
Use tariffs to force concessions from other countries, on trade but also on border control and increasing defence spending.
Use tariffs to boost investment and jobs in US manufacturing
Bring inflation down
Bring interest rates down
Reduce net immigration
Short-term – weaker demand
Near term the effect is like to be to slow spending. Big businesses are worrying about the impact of tariffs on their supply chains. Many businesses, big and small, fear higher prices for inputs, or for wages given the expected reduction in net immigration. Consumers too are showing uncertainty, again due to fears of inflation. Federal employees (2.3 million) and government contractors (around 4 million) fear they could lose their jobs, so will be cautious about spending. Recent immigrants may also be cautious about spending in case they are deported. There is a potential offset if people bring forward spending in fear of higher prices, but that would just delay the slowdown to later in the year.
Tariffs remove money from the economy – they are a tax on consumers – which reduces spending. The tariffs announced so far on Mexico, Canada and China (40% of imports) if fully implemented will remove about $140 bn from the economy (about ½% of GDP) according to the Tax Foundation. While many people still hope these tariffs will be reduced or eliminated in some sort of deal, this is far from certain, given Trump’s desire to raise revenues and reduce the budget deficit. Meanwhile, his ‘reciprocal tariffs’ plan due in April will likely raise tariffs on most imports from Europe and elsewhere so the tax hit could rise to about $300bn, or 1% of GDP. This will happen before any potential relief for consumers from lower taxes on incomes, so will reduce incomes.
Another short-run effect of tariffs will be to hit US exporters as countries retaliate. Again, this will be seen in reduced sales but also in more caution on hiring and investing. The US agricultural sector is deeply worried, especially with prices for soybeans and corn already well down from 2021-23 levels after the Ukraine shock receded. Farmers suffered from retaliatory tariffs in 2018-19 and received extra subsidies from the government.
Recent US economic data has been weak. Note that it is not as weak as the Atlanta Fed’s current ‘NowCast’ estimate for Q1 GDP ( -2.3% annualised) because this subtracts the surge in imports in January, including gold, from GDP but does not add it in to inventories which is where they will go in the GDP calculation. Still, a number of indicators are soft including business orders and consumer spending. It is too early to be sure how much the LA fires and winter storms contributed and how much is due to rising uncertainty. But the uncertainty around tariffs will likely increasingly show up in the data.
Expectations for slower growth have already appeared in market interest rates, with 10-year yields off about 50bps from their highs and up to 3 Fed rate cuts now priced in for this year (down to 3.5%). These will help the economy by improving housing and auto sales but only after a lag. Meanwhile, they could also raise fears of a full recession, adding to the economic uncertainty.
A failure to lift the debt ceiling this week (deadline March 14th) could also affect confidence and also directly lower spending in the economy. Lifting the debt ceiling requires 60 votes in the Senate so at least 7 Democrats must vote with the Republicans. A temporary government shutdown looks quite likely.
It almost goes without saying that Trump’s tariff agenda is already engendering business caution in China and Europe and, as tariffs bite, will also cause a near-term slowdown, or even potentially push the Euro zone and UK back into recession.
Higher inflation to keep the Fed on hold
The immediate effect of tariffs will be to raise prices in some sectors so we will see higher inflation readings as and when they come into force. The tariffs announced in early February (25% on Canada and Mexico, and 10% on China would add 0.5-0.8% to core PCE inflation according to a study by the Boston Fed. Trump has already added another 10% to the tariff on China products, for a total 20%, though the Canada and Mexico tariffs have been partially delayed. With this and similar tariffs placed on the EU and other trading partners the jump in the US inflation rate is likely to be in the 1-1.5% range.
This is a one-off effect and would not necessarily push up inflation permanently. There are worries though that, with the economy at full employment and the recent history of above-target inflation, wage growth could respond and inflation expectations become unanchored. This could even point to the Fed raising rates. But the slower economy described above makes a rate rise very unlikely. Still, that upward blip in inflation would make it more difficult for the Fed to cut rates unless the slowdown appears deep, especially since the Fed will regard the hit to growth as just as temporary as the rise in inflation. The risk of a policy mistake - not easing when they should or waiting too long to ease if the slowdown turns out worse than expected - is quite high.
Where will the budget deficit come out?
A crucial question for the long-term demand picture is where the budget comes out in the end. In 2024 the deficit was 6.5% of GDP, an extraordinarily high figure for an economy at full employment. I am sceptical that the DOGE effort will make the massive spending reductions that the President and Congress have talked about. So far, the savings are thought to be in the few tens of billions at most.
In round numbers total Federal spending is $7 trillion annually but about $5.2 trillion of that is for ‘mandatory items’ which includes social security payments, Medicare (for the over 65’s), Medicaid (for the poor), defence and debt interest. President Trump has said those items will not be cut, though many Republicans have identified Medicaid as an area for savings. Most observers believe that, in the end, total savings will be at most $200bn net, and more likely half that, with cuts probably falling hardest on Medicaid. Bear in mind too that Trump is spending more on border security and Congress wants to raise defence spending.
Tariff revenues may not be counted in the budget
I think it is likely that Trump will insist on significant tariffs as the end game, though exactly how high and on what and whom is still completely up in the air. Revenue from them could amount to up to $300bn as discussed above. But since they have not been legislated by Congress they would likely not be counted in the budget process since they could in principle be rescinded at a moment’s notice. Some observers believe that for this reason, the President will ask Congress to legislate them later this year. Or perhaps they will be counted informally.
In total, government spending cuts plus tariff increases could amount to $400-450bn or about 1.5% of GDP. If this sum was used for additional tax cuts (on top of extending the 2017 tax cuts) that would leave the budget deficit about the same. It would be enough to meet most of Trump’s desires (such as the reduction in tax on tips and social security and an additional cut in corporate taxes). Or there could be a reduction in the deficit. However, if Trump and Congress tried to do everything he wants on tax reductions, and especially if he backs away from tariffs, the deficit would likely rise.
Exactly how it will come out is anybody’s guess but mine is that the deficit will remain about the same near term, even if it is projected to come down later on. That would mean no new stimulus or contraction but would also leave the government debt ratio on an upward trend. A contraction in the deficit would be the most desirable outcome but that seems unlikely.
Higher US growth later on?
The case for arguing for higher US economic growth in 2026-27, after the initial tariff shock has passed, is as follows:
The loss of consumer purchasing power from the tariff increase is a one-off. New tax cuts on top of extending the 2017 tax cuts would support spending.
Uncertainty over policy will fall as businesses adjust to a US economy with lower imports and exports.
US and international firms will want to move high value production for the US market into the US. The economy is already at full employment so unemployment is unlikely to fall. Instead manufacturing employment may rise slightly (but not much because of automated processes) at the expense of other employment.
Corporate tax cuts and deregulation will make the US economy more attractive.
US defence contractors are set to enjoy high sales as Europe rearms.
Fiscal stimulus in Europe and in China is increasing which will help the US economy in time.
If this strong demand comes up against an economy near full employment then inflation risks will rise and interest rates are likely to head up again. Obviously, the path of the economy over the next year will matter. If it slows down a lot in the next few quarters, pushing unemployment higher, with even the possibility of a small recession, then an acceleration would be welcome and the inflationary consequences limited. However, if the slowdown this year is limited, say growth slows to the 1-1.5% range with unemployment moving very little, then the Fed would likely be tightening policy in 2026-7. If that does not happen because of Administration interference then the inflation risks would be high.
Note that all this is about the demand side of the equation and the potential implications for inflation and interest rates. On the supply side, the tariffs are a negative for US productivity growth as businesses are forced to use less efficient processes and substitute cheap imports for higher-cost domestic production. This loss of productivity may be partially offset by higher investment due to a lower corporate tax rate and a push to automation as US companies bring production back to the US in highly automated factories. But the overall effect will be to lower US living standards in the long term and make the US less competitive.
Implications for markets
The tariff drama and cutbacks in government spending point to a temporarily slower economy which means there is scope for lower bond yields. This has already happened to some extent, dragging down the dollar despite its natural tendency to rise on the imposition of tariffs. However, unless the economy looks particularly slow the Fed is unlikely to move much while the data is showing higher inflation readings (due to tariffs). This leaves stock markets vulnerable near-term to fears of a recession. Longer term, if a major downturn is avoided, a faster economy could boost profits growth, supporting the stock market.
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