The United States has announced steep tariffs on goods made in Canada, Mexico and China starting on Tuesday.
If the tariffs remain, they will trim 0.36 percentage points from U.S. GDP growth over the next 12 months, according to RSM’s modeling.
Even though Canada and Mexico have promised retaliation, we anticipate that the disputes with those two nations will be resolved in the near term, though the standoff with China will last longer.
If there is no resolution, the impact on the U.S. economy will be significant. Growth will slow notably from the 2.9% average over the past three years as inflation and interest rates rise. The yield on the 10-year Treasury, currently around 4.5%, could climb to a range between 4.75% and 5%.
At stake is about $1.323 trillion in trade imports that come from China, Mexico and Canada, accounting for 43% of U.S. imports and 5% of the $27 trillion U.S. gross domestic product.
The new import taxes—25% on goods from Canada and Mexico, and 10% in Chinese-made goods—will increase the average tariff rate from its current level of 3% to 10.7% based on contemporary trade patterns.
Should the trade skirmishes escalate to include the European Union and turn into an all-out trade war, expect U.S. economic growth to ease back to 2% as the tariffs drag down growth and employment, stoke inflation and widen the current account deficit, all amid higher interest rates. A recession, though, is unlikely this year,
That scenario of slowing growth stands in contrast with our current baseline forecast for the U.S. economy, which expects 2.5% growth this year accompanied by full employment and inflation between 2.3% and 2.5%.
As for Canada and Mexico, a continued standoff on trade will push those economies into recession.
China will feel the impact as well. China’s economy, which has been reeling from the implosion of its property markets, will suffer as tariffs lengthens its deleveraging process.
Investors and policymakers should also expect a decline in the purchase of agricultural exports from the U.S. and a near one-to-one percentage decline in the value of the yuan linked to the 10% increase in import taxes in the near term.
The forecast
If the tariffs stick, they will trim 0.36 percentage points from U.S. GDP growth over the next 12 months. At the same time, the personal consumption expenditures index, the Fed’s preferred inflation gauge, will increase by 0.4%, according to our modeling.
The tariffs will push up the PCE index, the Fed’s preferred inflation gauge, by 0.4%.
This estimate is modeled as an explicitly short-run phenomenon that includes retaliation but not currency depreciations or the erection of non-tariff barriers.
If currencies depreciate and non-tariff barriers are imposed, that scenario heightens the risk of a much larger drag on our estimates of GDP and inflation.
Those possibilities would lead the Federal Reserve to tighten its monetary policy, resulting in a much higher interest rate equilibrium.
Studies on the 2018 tariffs found minimal impact on importer prices.
This implies that export supply is perfectly elastic, meaning that U.S. consumers and importers bore all the tariff costs. The findings align with various estimation methodologies, showing that the costs of tariffs were passed through entirely to domestic prices.
Read more of RSM’s insights on the economy and the middle market, and go deeper on RSM’s perspectives about the effects of tariffs.
There are several explanations for this finding. In the short run, export prices may be sticky, but long-term adjustments could lead exporters to lower prices.
In addition, high policy uncertainty may have discouraged price cuts, as exporters feared they would not be able to raise prices again if tariffs were lifted.
That is the domestic price of a potential trade war.
According to research by Mary Amiti of the Federal Reserve Bank of New York and others on trade elasticity—where every 1% increase in tariffs corresponds to about a 6% drop in import quantities—we can estimate the deadweight loss resulting from these import taxes.
With tariffs of 25% on Canada and Mexico and 10% on China, GDP faced a $3.5 billion monthly drag, equivalent to 0.14% over 12 months.
We now know that Canada will retaliate with a 25% tariff increase on approximately $100 billion worth of U.S. exports. Assuming Mexico does the same and China imposes a similar 10% tariff increase, the deadweight loss would rise to $8 billion per month—or 0.36% of GDP over the next 12 months.
Again, the drag on GDP would be independent of the tax revenue the government receives from higher tariffs; in the short term, American consumers would bear the brunt.
More important, if the tariffs are sustained, then it is highly probable that the Fed’s rate-cutting campaign has come to an end and that the next move out of the Fed would be a rate increase.
This would push interest rates at the long of the curve higher, meaning a 10-year yield in the range of 4.75% and 5% or higher and mortgage rates moving well above 7%.
Should the import taxes be sustained, the impact on hiring is a bit more nuanced, with a potential wage price spiral being the biggest risk rather than lower unemployment.
Hiring will slow to a range between 50,000 and 100,000 per month, but the unemployment rate may not change much because of tighter immigration policies and a quicker pace of deportations.
Just as important, the combination of trade taxes and immigration restrictions could lead to a wage price spiral, which would result in rate hikes as the central bank attempts to quash resurgent inflation.
The takeaway
The combination of trade taxes and tighter immigration policies will put upward pressure on inflation. It runs the risk of creating conditions where the Fed may choose to increase rates rather than reducing them as prices and long-term interest rates reset higher.
There is ample rationale for all parties to arrive at a mutually agreeable cessation of trade tensions as soon as possible.
Need help mitigating the effects of tariff increases? Learn about RSM’s trade and tariff advisory services.
