Chief Economist Eugenio Alemán and Economist Giampiero Fuentes note that an across the board increase in tariffs has the potential to push inflation higher.
To read the full article, see the Investment Strategy Quarterly publication linked below.
A tariff is a tax assessed on imports. Historically, tariffs have been enacted to generate tax revenue or to protect domestic producers from competition in the form of cheaper foreign goods. In essence, tariffs artificially make domestically produced goods more competitive in the local market by making imports more expensive. At the same time, tariffs allow domestic producers to increase the price they otherwise would have charged for their product had they faced foreign competition. In many ways, trade without tariffs keeps domestic producers’ attempts to increase prices at bay. While tariffs have been utilized heavily in the past, both their usage and rates have fallen considerably over the past half century as countries have engaged in different stages of trade negotiations. The volume and value of global trade have grown exponentially as tariffs and barriers to trade have fallen over the decades. This has coincided with the growth of the global economy over the same period, which is, on average and in aggregate, more prosperous than at any time in human history.
While it is readily apparent that emerging economies have reaped outsized rewards because of freer trade, developed economies as a whole have benefited as well. The availability of cheaper imported goods has enabled consumers in developed economies to retain a larger share of their income for consumption, saving or investment. The same holds true for companies, which benefit from lower input costs and higher profit margins when there are fewer barriers to trade. The strength and dominance of the US dollar as the world’s dominant currency, helped by the sizable and consistent demand for U.S. financial assets, the growth of the U.S. economy, as well as the large fiscal deficits over the years, have all contributed to the increase in US consumption and thus to a sizable increase in imports from the rest of the world. This has created a large current account deficit (this includes the trade deficit in goods as well as the surplus in the trade of services), which needs to be financed with foreign savings. That is, the rest of the world has essentially financed the expansion of US consumption by purchasing U.S. financial assets and investing in its economy. In exchange, the rest of the world has been buying U.S. physical assets as well as receiving interest and dividend payments from these transactions. Thus far, this arrangement has, on the whole, greatly benefited the U.S. economy and will remain a non-issue as long as the U.S. dollar remains the world’s reserve currency and the US economy the preeminent place to invest.
The U.S. manufacturing sector has been transformed over the last several decades as cheaper imports have put pressure on the sector’s competitiveness. Higher manufacturing wages in the U.S. compared to the rest of the world are probably the root cause of such a shift. According to the National Association of Manufacturers (NAM), the average salary of a manufacturing worker in the U.S. in 2022 was $98,846, including benefits, compared to about $13,638 in China and $15,804 in Mexico.1 However, the sector's transformation has meant that it is using more machines and more skilled labor to produce goods and this requires fewer workers to produce than in the past. This means that the sector has continued to specialize in the production of those goods that it is most efficient in producing. That is, although employment in manufacturing declined by nearly 30% since the 1990s, manufacturing productivity has doubled during the same period. This increase in manufacturing productivity has meant that manufacturing workers are highly paid compared to workers in the developed world.
The COVID-19 pandemic, the government’s massive fiscal package, the inflation spike of 2022, and the Federal Reserve’s (Fed) monetary policy journey have certainly overshadowed any impact that the 2018 trade war might have had. However, that’s behind us, pandemic excess savings are depleted, inflation is close to the Fed’s target, the Fed has started to ease rates, and we are now staring at the possibility of a new trade war. While trying to estimate the effects of additional tariffs and potential retaliation from foreign countries is an extremely complex task with lots of variables at play, we’ve tried to estimate the potential impact on the U.S. economy from the imposition of a 10% import tariffs on all trading partners and 60% tariffs on all Chinese imports.
Under this scenario, the tariffs will generate ~$500B in revenues, which could, on one hand, have a negative impact on GDP if the revenues from tariffs are not returned to the economy. Typically, higher tariffs are paid by consumers through higher prices for the goods they consume. Furthermore, the impact on consumers, especially those in the lower income quintiles, could be severe as not only are they likely to have fewer options, but may be forced to spend much more as businesses will likely pass the bulk of the price increase to consumers. On the other hand, domestic producers will likely attempt to use the impact of tariffs on imported goods to boost their profit margins by increasing prices of competing domestically produced goods. Overall, if tariff revenues increase more than sixfold (from $80 billion to $500 billion) then the extra amount that the average household will have to pay increases from ~$300 annually to ~$1,900 annually and impacts the US economy by as much as 1.9% of total GDP.
If these tariffs are enacted, a trade war is likely to ensue as trading partners retaliate by imposing similar tariffs on US exports. In this escalation, the trade deficit will likely widen further, and US exporters may experience as much as a ~$400B hit on revenues depending on how much the quantity demanded by trade partners will decline. Additionally, if the US dollar were to appreciate in response to the tariffs, U.S. exporters would have a harder time selling their products overseas, which would likely have a negative impact not only to exports, but also to US production and the labor market.
Inflation is likely to increase as tariffs are implemented and prices increase, but unless the trade war continues over the years, the inflation spike may be short-lived. However, if inflation increases then the Fed may be pushed to either increase interest rates or keep interest rates higher for longer compared to a no-tariff-war scenario or until the effects from the tariffs are pushed through the U.S. economy. It is difficult to know the actual impact on overall inflation, but an across the board increase in tariffs has the potential to push inflation higher.
Those who believe that freer trade is not good for a country believe that international trade is a ‘zero-sum game,’ which means that if one country loses, that is, has a trade deficit, then the country with the corresponding, and opposite, trade surplus, is the winner. However, trade is, typically, not a zero-sum game but a ‘positive-sum game’ in which everybody wins by engaging in trade. The idea that a trade surplus is better than a trade deficit comes from the old and discarded theory of ‘mercantilism,’ a view of the world that lasted from the 16th to the 18th centuries and that considered the wealth of a nation dependent on the size of its trade surplus while limiting imports through the imposition of tariffs.
However, the reality is more complex. As discussed above, trade deficits and surpluses do not necessarily denote whether a nation is at an inherent economic advantage or disadvantage. In this sense, trade is more like a ‘positive-sum game’ with a variety of possible payoffs. Generally speaking, all nations stand to benefit by ‘cooperating’ in an environment of freer trade. However, tariffs and protectionist measures disrupt global supply chains, increasing costs and reducing profitability. In other words, nations stand to be harmed by ‘defecting’ from free trade and engaging in trade wars.
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Investment Strategy Quarterly
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