The United States and China over the weekend agreed to pull back from the precipice of a full-blown decoupling and have agreed to an effective 30% tariff on all imports into the U.S. and 10% on exports into China.
The reduction in tariffs, announced for 90 days with further talks to come, prevents a dire scenario of a complete decoupling between the countries, and it improves the domestic outlook assuming firms resume making investment and hiring decisions that have slowed in recent weeks.
But this truce will provide little solace for small and medium-sized firms that do not have the financial depth to absorb the higher costs. The result for those firms will be a significant decline in revenues and profit margins.
Large firms will adjust accordingly and balance the increase in costs with a slower pace of investment and hiring, including likely layoffs, when demand eases on the back of a large effective increase in consumption taxes.
The bottom line is that American firms can now prepare for a significant increase in the cost of imports, which will then be passed along to consumers.
How this works
Our back-of-the-envelope calculation implies that a firm importing goods from China should prepare for a 30% tariff in addition to another 2% because of the Chinese adjusting the yuan downward at the start of the trade conflict.
The firm will then decide how much of the 32% increase in the cost of importing it will absorb.
Following the 2018-20 trade conflict, at least 90% of the increase in the tariff was passed through to consumers, research shows.
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Going forward, businesses will need to decide how much to pass along based on the individual tariff for each imported item and whether the dollar has appreciated or depreciated since the tariffs were imposed in early April.
While large firms for the most part will have effective hedges in the foreign exchange markets to account for this outcome, it is small and medium sized firms that almost exclusively will not have such financial insurance in place and be forced to bear a much larger portion of the tariffs’ cost.
The takeaway
Passing through prices for many firms and down-market consumers will be noticeable.
That pass-through will feed into the calculation of inflation expectations, which will be critical for the Federal Reserve as it sets the policy rate.
In the immediate aftermath of the China agreement, investors are pricing in two rate cuts of 25 basis points each this year from the central bank.
It would appear that the administration will insist on a 10% tariff on most items entering the country. For the most part, firms can absorb an increase of that size, and we are confident that companies can now begin making hiring and investment decisions albeit at a higher cost of doing business.
One should assume that at least 90% of that tariff will get passed through to consumers.
