Introduction to Tariffs
The United States has implemented a significant increase in tariffs, with the effective average tariff rate now standing at roughly 18%, according to calculations made by the Yale Budget Lab. This rate is the highest since the early 1930s and has increased by 15 percentage points since the start of the year. To understand the potential impact of this increase, it’s essential to look at the historical context and the possible effects on the economy.
Historical Context of Tariffs
In 1930, the US Congress enacted the Smoot-Hawley Tariff Act, which increased the average tariff rate by 6.5 percentage points. This led to retaliation from other countries, resulting in a massive reduction in global trade and exacerbating the Great Depression. Although there has not been substantial retaliation this time, the increase in prices and the commensurate reduction in purchasing power will likely have a negative impact on US growth.
Potential Impact on Economic Growth
The Yale Budget Lab estimates that real GDP growth in 2026 will be 1 percentage point below the baseline forecast, and in the years to come, annual growth will be 0.5 percentage points below the baseline. This assumes that the current tariff rates remain in place. The reduction in growth will likely be driven by weakness in both manufacturing and construction. Although durable goods manufacturing is expected to improve, other areas of manufacturing may worsen, especially advanced manufacturing.
The Reality of Tariff Increases
An 18% tariff applied to last year’s US$3.3 trillion in imports implies roughly US$600 billion in additional annual government revenue, or about 2.1% of GDP. This can be thought of as an annual tax increase of 2.1% of GDP, more than offsetting the impact of the tax cuts in the bill recently passed by the US Congress. All other things being equal, this will likely have a sharp negative impact on real GDP growth. Moreover, even if the tariffs are not fully passed onto consumers, businesses will see a sharp decline in profits. Either way, there could be a negative economic impact.
Shifts in Trade Patterns and Supply Chains
On the other hand, such a large increase in the prices of imported goods would likely lead to a decline in the volume of imports, thereby reducing the net impact on GDP. If there is a substantial decline in the volume of imports, that will be a negative shock to the exports of other countries. Moreover, if businesses begin to see the new level of tariffs as permanent, it will likely lead to a redesign of supply chains as well as significant shifts in global trade patterns.
Challenges with Tariffs as a Source of Revenue
One might argue that, given the large US budget deficit, a tax increase might be welcome. Yet, the challenge with tariffs as a source of revenue is that they have different impacts on different industries, shift production toward lower value-added processes, hurt business investment, exacerbate income inequality, and could ultimately damage productivity and growth.
The Potential Inflationary Effect of Tariffs
Meanwhile, there continues to be debate about the potential inflationary effect of tariffs. Many analysts have noted the lack of significant US inflation so far this year. Some analysts have suggested that there won’t be significant inflation, pointing to foreign exporters taking a hit to margins by lowering export prices and domestic sellers also taking a hit to margins by not fully passing on tariffs to their customers. However, it is likely that these companies attempted to maintain market share on the expectation that tariffs would be temporary.
Expectations of Price Increases
My expectation is that once companies recognize the permanence of tariffs, they will raise prices accordingly. Indeed, one large consumer products company announced that, in the coming year, it will boost US prices by 5% to offset the US$1 billion impact of tariffs. Also, investors evidently expect tariffs to boost inflation, as indicated by the increase in the five-year breakeven rate, a measure of bond investor expectations of average inflation over the coming five years.
Investor Expectations and Economic Indicators
Investors are not changing their view about growth, only their view about inflation. On the other hand, many investors believe that tariffs will weaken growth, and the boost to inflation will be relatively short-lived. As such, the futures markets indicate that investors expect the Federal Reserve to cut the benchmark interest rate two to three times before the end of this year.
Recent Economic Data
The US government released monthly data on personal income, consumer expenditures, and the Federal Reserve’s favorite measure of inflation, which is the personal consumption expenditures deflator, or PCE-deflator. This measure of inflation accelerated modestly in June, with prices up 2.7% from a year earlier and up 0.3% from the previous month.
Real-World Impact of Tariffs
However, the most notable part of the report concerns prices of durable goods, many of which are imported. The PCE-deflator for durables increased 0.5% in both April and June versus the previous month, the biggest gain since mid-2022. In addition, the PCE-deflator for durables was up 0.9% from a year earlier in June, the biggest gain since December 2022. Normally, prices of durables decline. Plus, the government also reported that the real volume of durable goods purchased by consumers fell sharply.
Early Evidence of Tariff Impact
This is early evidence of the impact of tariffs. Moreover, these increases do not yet fully reflect the impact of tariffs as businesses have cut prices to partly offset tariffs, resulting in weakened profits. This will not likely continue, especially as it is now clear that high tariffs are here to stay. Thus, expect inflation to accelerate in the months to come. The Yale Budget Lab estimates that, if businesses fully pass through the impact of tariffs, inflation will nearly double in the coming 12 months.
Conclusion
In conclusion, the recent increase in tariffs by the United States has significant implications for the economy. The increase in prices and reduction in purchasing power are expected to negatively impact economic growth. While there may not be substantial retaliation from other countries, the impact of tariffs on trade patterns, supply chains, and inflation will be considerable. As businesses adjust to the new reality of high tariffs, prices are likely to increase, leading to a potential surge in inflation. It is crucial to monitor these developments closely to understand the full extent of the impact of tariffs on the US and global economies.
