While the details of the escalation of tariffs is a rapidly moving feast, firstly from the erratic nature of the Trump administration’s policy formulation, but also in the retaliatory action of many of the impacted countries, there are some clear cut economic and market consequences that result from high and rising tariffs.
At its most fundamental, as tariffs are implemented and then remain in place for an extended time, the underlying pace of economic growth is dampened. This is clearly most directly linked to the countries specifically impacted by the tariffs, but it also applies to the broader global economy as trade flows slow with those countries caught in the blow-back from the impacted parties.
By way of example using US tariffs on steel and aluminium as a guide, firms paying tariffs on those goods will pass on the dollar value of the tariff to their clients. The tariff impost cannot be absorbed into their margins which means that, in simple terms, prices rise.
As prices rise, demand falls and steel and aluminium output and usage will fall. This means growth and trade are undermined.
There are other effects. As users of steel and aluminium as vital inputs pay more – a couple of examples in the US are manufacturers of aircraft and beer cans – these higher input costs feeds into final selling prices of planes and beer. Inflation in other words.
From a financial markets perspective, weaker economic growth and higher inflation implies a structurally higher level for interest rates and bond yields than would otherwise be the case and weaker profits which will bias equity prices lower – or at least limit the extent of increases.
There is a longer run economic effect of tariffs which is potentially important. It is a reversal to the past four decades where tariffs were generally low, inflation was contained and productivity was strong.
This effect is captured in the expansion of otherwise inefficient, unprofitable and uncompetitive businesses. When exposed to open competition in a low tariff world, these firms would not be able to compete with international competitors. In economics, low tariffs and free trade delivers the benefits of specialisation.
This is why, to take an extreme example, New Zealand does not manufacture cars, but still drive them, and the dairy industry in Saudi Arabia is tiny, but people still consume dairy products.
In this stylised and illustrative example, New Zealanders buy quality and cost effective cars from efficient car manufacturers; they pay for those cars as a country with dairy products which they produce efficiently; Saudi Arabia buys dairy products with the oil it sells to the world and so on.
Under the protection of tariffs, firms which would otherwise compete with efficient producers can function knowing that they have a protective advance on those competitors by the amount of the tariff. It implies that these firms can be viable but only in their domestic markets under the protection of tariffs, even if they are inefficient relative to their international competitors.
In other words, tariffs add to inflation in a serious, structural sense.
Initial market reactions show this
The last two months where tariffs have been imposed and proposed, there has seen a lift in volatility in stock and bond markets.
In this time since Mr Trump was sworn in as President of the US, whenever there has been an escalation in the imposition of tariffs and / or retaliatory action, most notably from Canada and China, stock prices have fallen, sometimes sharply. In net terms, bond yields have been little changed but this is more likely to have arisen from reaction to other fundamental data and policy deliberations from the Federal reserve as much as the tariff issue.
Suffice to say, the markets are alert to the fall out from a trade and tariff war.
The US dollar, having had several years of unrelenting strength, has been biased lower in part due to the policy and economic uncertainty coming from the US administration.
This is a short-term example of what can be expected to happen in a structural sense if there is a further escalation in tariffs in the months ahead.
Suffice to say, tariffs weaken growth in the global economy, add to prices and restrict the productivity of specialisation.
This article was written and contributed by Stephen Koukoulas