We’ve written quite a bit on tariffs already this year, and appropriately so. Developments on this front have been significant and are of global consequence.
Nonetheless, we continue to get questions in this area. Following are some thoughts on three aspects we’re being asked about most frequently.
Do tariffs cause inflation?
This might seem like a simple question, but the answer is complicated.
The impact of tariffs on prices depends on many things. Importers may accumulate inventory before tariffs go into effect, delaying the impact. When a new levy becomes effective, foreign exporters sometimes lower their prices to maintain sales. From there, importers can choose to absorb the costs of trade in their profit margins instead of passing them along to retailers.
If higher prices filter down to consumers, buying behavior can change. Demand can shift to near-substitutes or be deferred when possible. This is why the best inflation gauges are “chain-weighted,” meaning that the basket of goods and services used in measurement shifts in reaction to what people are actually buying. The Federal Reserve targets 2% inflation on this basis.
For now, the impact of tariffs on demand in the United States is expected to be modest. But in other markets, the damage to consumption could be so large that the overall pressure on prices is downward. This may be the case for Canada, as one example.
Additionally, keep in mind that inflation is the rate of change in prices. If the cost of an item jumps, but then stabilizes, its impact on year over year differences gradually diminishes. Economists call this a “level change.” Central banks may be inclined to “look through” those shocks to focus on longer-run conditions.
Tariffs lift inflation for 2-3 years after they are implemented.
But while the impact on inflation may be short-lived, high prices linger in the consciousness of consumers. We highlighted this last summer, in our essay “Inflation has a perception problem.” Price shocks can influence inflation expectations and wages, which can broaden the influence of tariffs. Recent readings reflect expectations of much higher inflation over the next twelve months, but not as much change over longer periods of time.
The Federal Reserve released a comprehensive study of tariffs last month. Using international data from 1995 to 2020, researchers found that a 10% increase in trade costs adds (on average) about 0.5% to inflation in the first year. That diminishes gradually over a 2-3 year period. While that is a good rule of thumb, every situation is different. And current circumstances, which find tariffs escalating very rapidly across the globe, may stretch the relevance of the paper’s conclusions.
In sum: yes, tariffs cause inflation. But how much and for how long is difficult to pinpoint.
Are tariffs ever justified?
In a perfect world: no. In our complicated and interconnected world: sometimes.
It is not uncommon for developing countries to use tariffs to shelter nascent industries, so as to become more self-sufficient. The early history of the United States was no exception; the aggregate tariff rate in the 1830s was well over 50%. Protections are usually negotiated away as domestic firms achieve scale and competitiveness.
Tariffs can also be used to address a range of anti-competitive behaviors. State-owned and state-sponsored enterprises have preferred access to capital and labor, and can sell below costs. Producers in some countries are subject to more lenient labor or environmental regulation. Placing duties on imports from these markets attempts to level the playing field so that domestic providers can compete fairly.
As well, tariffs can be used to counter other forms of trade restriction. Domestic content rules, quotas and regulation are often employed as forms of protection. One-sided tariffs are sometimes used to seek redress from these tactics.
Once initiated, however, tariffs are difficult to remove. They sometimes outlive their intended purpose, and end up becoming offensive and not defensive. Delicate trade negotiations are required to regain balance.
Reciprocal tariffs could hit Europe and Asia particularly hard.
What is the next major milestone in the trade war?
In mid-February, the White House issued an executive order entitled “The Fair and Reciprocal Plan” for trade. It chartered work to remedy situations where countries charge higher tariffs than the United States does. Actions based on the results have been promised for April 2.
The Administration’s proposed approach is simple: if a country places a tariff on an American product, an equal tariff will be placed on comparable imports. That may seem reasonable on the surface, but there are complications to consider. Applying reciprocal tariffs at a product level would require defining product categories and contents very carefully, to limit avoidance. Administering such a system would be complex and time consuming.
Reciprocal tariffs could be applied at a country level. If, for example, France charges 5% duties on American imports, we would charge 5% on all French imports. This would be much easier to implement, and potentially offer a reprieve to sectors that currently face high import duties. India and a number of Asian countries would be most vulnerable to this approach.
But the calculus could be complicated by the Administration’s insistence that value-added taxes be included in the determination of reciprocal tariffs. This would create a substantial escalation in new duties against Europe: ABN AMRO estimates that it would add more than 20% to the tariff rate applied to EU exports to the United States, a staggering level.
It is not clear how reciprocal tariffs would relate to those already in force. If they are additive, then the level of U.S. trade restriction could rise to a 100-year high.
Adam Posen, the eminent economist who leads the Peterson Institute, recently observed that the United States seems to be declaring a trade war…on itself. We’d certainly like to see the conflict settle down, so we could turn our attention to other, more pleasant subjects.
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