America's next top model: Tariff edition

Summary

Prospects for a trade war are transitioning from a looming threat to looming policy. While most of the latest proposal is now on ice, our model simulations demonstrate how the latest round of proposed tariffs could introduce a modest stagflationary shock by negatively impacting growth and temporarily boosting inflation.

Begun the trade war has

For something that was widely telegraphed, the nearing implementation of tariffs still managed to introduce disorder into financial markets. In this report we unpack what has changed as a result of the new trade policies put into effect by President Trump and offer a framework for thinking about the economic impact of these changes.

Two weeks to the day from his inaugural address, President Trump is close to making good on his promise to use tariffs as a tool to achieve various, albeit at times conflicting, policy aims. Specifically, the President has come within a whisker of implementing the following tariffs:

• 25% tariff on non-energy Canadian goods, 10% on Canadian energy goods (postponed for 30 days).

• 25% tariff on Mexican goods (also postponed for 30 days pending negotiations).

• 10% tariff on goods from China.

There is little that is certain about current U.S. trade policy, though the fact that the tariffs on Mexico and Canada were temporarily suspended suggests that the duration of these levies are not immutable. To the extent that the trade tariffs remain in force, they will have clear impacts on the economy. In a recent special report, we discussed how 25% tariffs on our North American trading partners would cast both those economies into recession while reducing U.S. GDP growth by a full percentage point relative to its status-quo baseline. Also, the annual rate of consumer price inflation would be half-a-percentage point higher by year-end than it otherwise would be in the absence of these specific tariffs.

While the exact timing and final size of the current tranche of tariffs under discussion remains in flux, the events of the past few days send the strongest signal yet that a step-up in tariffs is quickly approaching. To better understand how the tariffs taking shape would impact the U.S. outlook, we look at two new tariff scenarios:

Scenario 1: All the tariffs listed in the bullets above go into effect in the first quarter of this year and the affected countries retaliate.

Scenario 2: Prices in the potential expansion of the trade war to include the rest of the world by adding additional 10% tariffs across-the-board for the rest of the world to Scenario 1, as well as retaliatory tariffs on U.S. exports of 10%. Because these tariffs may not be implemented fully and both the timing and duration are uncertain, this second scenario is a dire case.

Like the other tariff scenarios about which we have written, this particular brew would impart a modest stagflationary effect on the U.S. economy. The down-to-the-wire implementation of steeper tariffs on some of our largest trading partners points to major changes to trade policy happening sooner rather than later, and warrants a look at how the impact to the economy would unfold over the coming quarters. Applying the tariffs outlined above into a macroeconomic model of the economy points to an immediate increase in consumer price inflation. Specifically, the model points to the year-over-year rate of the CPI rising 0.7 percentage points above its pre-tariff baseline in the first quarter tariffs are implemented. While the quarterly lift to the rate of inflation fades over the first year in which tariffs take effect (Figure 1), the level of prices would be 0.3% higher at the end of our forecast horizon in 2026.

The projected higher price level comes despite weaker growth in the first year in which tariffs are enacted. The model shows that the largest downward impulse to economic growth occurs one quarter after tariffs take effect, at which time the annualized rate of real GDP growth is about three-percentage points lower than the baseline. While growth subsequently picks up a year after tariffs are implemented, the U.S. economy would be about 1% smaller at the end of 2026 in the more targeted tariff scenario, and nearly 2% smaller in the expanded trade war scenario relative to the model's baseline (Figure 2).

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