System Shock

• The administration’s move to high tariff barriers on US goods imports will usher in a stagflationary environment in the near term.

• If sustained, tariffs will prompt a costly and laborious reordering of global supply chains.

• Fiscal policy may be used to counter the negative growth effects of tariffs, but would only add to inflationary pressure.
   

The Trump administration’s implementation of sizeable global tariffs represents a profound economic shock that moves the near-term outlook in a decidedly stagflationary direction, lowering inflation-adjusted household income and raising the level of unemployment. Longer term, the unfolding trade war with major trade partners, if sustained, will reorder decades of global supply chain integration and remake the global financial system. Quite simply, tariffs of this magnitude represent a regime shift that is likely to have consequences for the economy for years to come. Protectionism also fits within the broader pattern of the administration’s efforts to roll back many of the norms and institutions of the post-war international order.

Figure 1: Effective Tariff Rate

Static calculation based on composition and level of 2024 imports

Source: The Budget Lab, MacKay Shields.    

To date, tariffs announced by the Trump administration will quickly take the effective tariff rate to levels not seen since the early part of the 20^th century. The effective tariff rate will then drift lower over time, not only due to the shifts in trade flows that tariffs induce, but also as a result of ongoing negotiations with many of our largest trade partners. In addition, judging by delays in implementation of some tariffs and exemptions granted to some imports, the administration now appears to appreciate the near-term harm that protectionism and retaliation can cause to households and businesses. The market reaction to tariffs, especially broad-based dollar depreciation and the rise in long-term Treasury yields, likely had a disciplining effect on economic policy as well. 

All this suggests that we are likely already past “peak tariffs”. Still, given President Trump’s long-standing belief that protectionism can revitalize the US manufacturing sector, there are meaningful constraints on how far tariff levels can fall from here. Looking forward a year or two, the economy is thus likely to face a steady-state level of trade protection that would still represent a major shift in trade policy. That steady-state tariff regime could include:

• A minimum 10 percent global tariff baseline;
  
  
• Higher tariffs on a range of imports from China, including both intermediate goods used in production and final consumer goods;
  
  
• A tariff rate as high as 25 percent on sectors deemed of national security or symbolic importance, including steel, aluminum, pharmaceuticals, microprocessors and motor vehicles; and
  
  
• Some “reciprocal” tariffs set on a country-by-county basis aimed at reducing bilateral trade deficits and incentivizing a more level playing field for US businesses operating abroad.
   

While tariff rates may continue on a gradual downward trajectory, still-high levels of tariffs imply a much weaker growth outlook for this year, with elevated risks of a recession. While tariffs will lead to a near-term improvement in net exports, this modest boost to growth will be more than offset through the following channels:

• Consumption tax: tariffs will increase prices faced by consumers, reducing real income and spending.
  
  
• Margin compression: to the extent some of the tariff duties are absorbed by businesses, the resulting margin compression will restrain hiring and investment.
  
  
•  Uncertainty: the lack of clarity about the long-term steady-state for tariffs, including the on-again/off-again nature of their implementation, will keep uncertainty elevated, further weighing on business investment and hiring. The uncertainty may also lead households to build up precautionary savings at the expense of consumption.
  
  
• Financial conditions tightening: Declines in the stock market will weigh on consumer and business sentiment, further reducing aggregate demand, while the rise in consumer borrowing rates and wider credit spreads will have a similar impact.
  
  
• Retaliation: Retaliation from our major trading partners will hurt foreign sales for a range of US firms, further impacting hiring and investment.
   

These effects of tariffs on economic activity will drive real GDP growth sharply lower this year, to below 0.5 percent on a Q4/Q4 basis. This growth estimate also incorporates the effects of weaker population growth resulting from the administration’s migration policies, which will constrain labor availability while also reducing aggregate consumer spending. With economic growth slowing meaningfully from 2024’s 2.5 percent pace, the unemployment rate is likely to rise to five percent by early-2026. Households will not only face weaker job prospects, but tariffs will put upward pressure on prices, taking the core rate of PCE inflation to above four percent by year-end from 2.8 percent currently, undoing a meaningful portion of the disinflation of recent years.

Figure 2: The Misery Index to Rise Through Year-End

The Misery Index is the sum of the unemployment rate and core PCE inflation.

Source: Bureau of Labor Statistics, MacKay Shields

Given the stagflationary consequences of such a profound shift in trade policy, along with the haphazard manner in which tariffs have been announced, measures of household and business expectations have deteriorated sharply in recent months. This deterioration, however, may also reflect broader concerns about the direction of economic policy, concerns that may also be reflected in asset price movements that include a sharp decline in equities accompanied by higher long-term Treasury yields and a weaker dollar. Specifically, not only is the economy set to experience a rare policy-induced slowdown, but there are a number of tensions, if not contradictions, at the core of the administration’s economic policy goals and actions. These include, for example:

• A desire to eliminate trade deficits while preserving capital inflows (i.e., simultaneously running current and capital account surpluses)
  
  
• Restoring the manufacturing sector while pursuing policies that reduce the supply of workers available for the onshoring effort
  
  
• Seeking lower long-term yields while engaging in fiscal expansion
  
  
• Using tariffs for both protectionism and as a source of long-term revenue
   

These tensions in economic policy are likely to persist beyond this year, suggesting elevated levels of uncertainty and persistent market volatility. In addition, any attempt to use fiscal policy to counter the adverse growth effects of tariffs and foreign retaliation would only further complicate the inflation outlook. This would likely lead to higher long-term yields as investors demand extra compensation for inflation risks and anticipated increases in Treasury supply.

Figure 3: Composite Business and Household Expectations Index

Shading represents NBER recessions.
Source: Source: Federal Reserve Banks of New York, Philadelphia and Dallas, Chief Executive Group, University of Michigan, Conference Board, S&P Global, National Federation of Independent Businesses, MacKay Shields.

The combination of weaker growth and higher inflation creates a challenging environment for the Federal Reserve, even setting aside pressure from the President to lower rates. Thus far, policymakers have generally stressed that with the economy still on a sound footing, they can afford to be patient in making any adjustments to policy. More recently, however, a new strand of thinking appears to be creeping into Fed communications. In an April 14 speech, Governor Waller remarked that under his baseline of temporary inflation effects from tariffs, he would advocate for responding to elevated recession risks with rates cuts “sooner, and to a greater extent than I had previously thought”. This view hinges critically on inflation expectations remaining well-anchored. There has been some upward drift in survey measures of household and business inflation expectations, but policymakers have recently put more weight on market-based measures that suggest well-anchored long-run inflation expectations. For example, inflation swap markets discount a much higher inflation outcome over the next year, but forward rates suggest sharply lower inflation thereafter. This may reflect the elevated probability that investors attach to a recession. And this is precisely the challenge facing the Federal Reserve. Steps to counter recession risks with more accommodative policy may undo the stability in inflation expectations that justified lowering rates.

Figure 4: Market-Based Measures of Inflation Compensation Remain Well-Anchored Beyond this Year

Source: Bureau of Labor Statistics, Barclays