In any trade negotiation, the last few innings are usually the most fragile since that is when more difficult issues are addressed, and the U.S.–China negotiations in early May are certainly proof. We had shared in the growing optimism that a deal would be secured given the political appetite on both sides, although we did note the inherent fragility of late-stage negotiations. Even with that caveat, however, the hardline pivot over the week of 6 May and the U.S. decision on 10 May to increase tariff rates on Chinese goods have taken virtually everyone by surprise, including us.
Now that U.S. tariffs have increased to 25% on $250 billion of Chinese goods, there is a real possibility that tensions between the U.S. and China could continue, if not escalate.
China on Monday responded with its own tariffs on $60 billion worth of U.S. goods. Beginning on 1 June, China will raise to as high as 25% tariffs on products currently taxed at 5% to 10%.
We understand that U.S. Trade Representative Robert Lighthizer is working on a list that is likely to include proposed tariffs on some or all of the $300 billion of Chinese products that are not currently subject to any U.S. tariffs. Similar to previous tariff rounds, this list would be subject to a notice and public comment period, as well as hearings to gain public input, meaning the earliest we could see any additional tariffs – if the Trump administration decides to move forward – is early July.
Barring a trade deal by the G20 summit in June, which could come together if President Donald Trump pivots again or China makes significant concessions, we see the recent jingoistic rhetoric as inhospitable to a deal, thereby increasing the possibility that Trump will move forward with these additional tariffs and escalate tensions.
Why the sudden return to tariff talk? For one thing, Trump believes that tariffs work not only in increasing leverage over negotiating partners, but also, in his view, in raising revenue for the U.S. government. (Many would argue that the revenue is not entirely collected from China, however.)
Additionally, and importantly, years of negotiating with China have left bipartisan scars in Washington. U.S. negotiators feel that many previous negotiations have played out in a similar fashion: lots of talk, promises of concessions, and perceived advancement, followed by equivocation and backpedaling when the time actually came for China to deliver. While other administrations have pursued a more patient approach, Trump (and many other policymakers in Washington) seems to have little tolerance for this now and is willing to take a more direct approach.
Lastly, China trade issues play well with Trump’s base politically, so keeping them in the headlines as the 2020 campaign season intensifies could have benefits for the president.
What are the economic impacts?
So far, the observed economic outcome since the U.S. levied its initial 10% tariff on China in September has been somewhat more muted than expected.
In a previously published blog post, we estimated that the direct economic impact of increasing tariffs to 25% on $200 billion of Chinese imports could add around 0.3-0.4 percentage point (ppt) to headline CPI inflation and subtract a similar amount from real growth over the year following implementation.
However, reported consumer price inflation in the various products subject to the additional 10% import levies – household furnishings, personal care products, bikes, and fish – has accelerated only 1.5 percentage points and, based on our analysis of Bureau of Labor Statistics data, contributed around 0.05 ppt to headline inflation, implying the inflationary effect of the 25% tariffs would be less than half of our ex-ante estimates. This, coupled with the minimal apparent influence on U.S. import and export prices, suggests that the brunt of the price shock is being absorbed by domestic corporate profits, which have been padded by earnings gains from the Tax Cuts and Jobs Act’s reduction of the corporate tax rate (according to a recent paper by the National Bureau of Economic Research).
Meanwhile, a separate detailed analysis of the ex-post effects of tariffs recently published by the NBER found that trade policy has created winners and losers but that the net welfare losses have been flat for the American economy as a whole. American businesses and consumers have lost roughly 0.3 ppt of GDP in total due to higher prices for imported goods and lower prices for exported goods – regions that rely on agricultural output have been particularly hard hit. However, higher government revenues from the tariffs and the gains for American producers have fully offset any income losses.
Could other headwinds to growth develop out of the tariffs?
These studies suggesting that the economic effects of tariffs have been milder than initially thought could be emboldening the Trump administration to do more. However, we think it’s important to keep in mind that indirect effects, including higher business and consumer uncertainty and elevated market volatility, can be meaningful headwinds to U.S. growth. Since the U.S. imports more Chinese goods than it exports, China can retaliate through non-tariff measures that result in write-downs of corporate investments in China and heightened financial market volatility.
The economic and market volatility around year-end 2018 serves as a reminder of the possible disruptive effects. Ahead of the original 1 January 2019 scheduled tariff increase from 10% to 25%, business and consumer confidence deteriorated, financial conditions tightened, and U.S. business sales recorded the largest monthly decline since 2015, according to U.S. Commerce Department data, with retail sales falling the most since the 2009 recession. Although the economy ultimately rebounded in the first quarter of 2019, this recovery has come in the context of optimism for a U.S.–China trade deal and a pivot away from rate hikes by the Federal Reserve. Following the Monday morning news of China’s $60 billion response, the S&P 500 closed 2.4% lower – not a major correction and markets could rebound any moment, but the decline underlines our note of caution.
What’s the bottom line?
After the surprise trade policy pivot by the U.S. and the escalation of tariff rates on Chinese goods, we may be entering another period of contentious trade negotiations. Because the observed economic effects of the tariff policies so far have been somewhat more muted than initially thought, the Trump administration may be emboldened to do more. But larger economic effects could ensue from the tariffs due to rising uncertainty and tighter financial conditions.
Overall, we continue to view the administration’s trade policies as an important downside risk to our cyclical outlook for growth. Although tariffs should temporarily support inflation, the downside risks to real growth aren’t good news for Federal Reserve officials, who, according to Vice Chair Richard Clarida’s comments in a recent speech, stand ready to cut rates if needed.