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When and How Much Tariff Effect?
As we look forward to the CPI report next week, the monthly-repeating theme is ‘when will the tariff effect show up?’ The answer, so far, is ‘not yet,’ but economists who had forecasted the end of life as we know it when the Trump tariffs went into effect have been befuddled.
I’ve already admitted in this column that I was educated in the tradition of ‘tariffs bad,’ but that over the years Trump’s insistence otherwise has made me carefully re-think of which ways tariffs are truly bad, and which ways they’re not so bad. Naturally, if tariffs were uniformly bad – which seems to be the orthodoxy – then it would be really hard to explain why almost every country levees tariffs. Maybe forty years ago we could blame the benightedness of those poor policymakers in other countries, who clearly just didn’t understand how bad tariffs are. But now? Heck, all someone in one of those countries needs to do is ask ChatGPT ‘are tariffs bad,’ and they’ll learn!
… Conclusion: Tariffs can be useful tools in specific, limited circumstances — like protecting vital industries or responding to unfair trade practices. But long-term, high or broad tariffs often do more harm than good, especially in highly interconnected global economies. (ChatGPT, July 9, 2025 query ‘Are tariffs bad’)
But it seems every country has these specific limited circumstances! It’s evidently only bad when the US does tariffs. And that is what made me ask whether maybe there is some nuance. My 2019 article “Tariffs Don’t Hurt Domestic Growth” was really good, I thought.
Even as there has been some small movement in the economintelligencia, though, about whether tariffs are all bad there has been very little movement in the notion that they are clearly inflationary. No doubt, implementing a tariff will raise prices at least a little, but how much is the important question. And regardless of that answer, tariffs are a one-time adjustment to the price level even if that effect is smoothed over a period of time. (This is why it’s weird to hear Powell say that the Fed can’t ease because they’re waiting to see the effect of the tariffs on inflation. That’s economic nonsense. The Fed can’t possibly believe that keeping rates high is the proper response to a one-time shock.)
On this question, I thought I’d share something I wrote in our Quarterly Inflation Outlook from Q1 (in mid-February), in which I roughly estimated the effects of a 20% blanket tariff. I know the answer isn’t “right,” because that’s the wrong question – there isn’t a 20% blanket tariff. But I undertook the estimate to get an idea of the relative scale of effects. (I included in the piece some parts from that 2019 article mentioned above, because I’m not above stealing from myself!) I will add some concluding thoughts after this ‘reprint’ from our QIO – which, by the way, you can subscribe to here.
Tariffs as a Tool to Promote Domestic Growth and Revenue
In the President’s view, the fact that the U.S. has a very low tariff structure compared to the tariffs (and arguably VAT taxes) that other countries place on U.S. goods is prima facie evidence that the U.S. is being taken advantage of and treated unfairly on world markets. The U.S. has, for the better part of a century, been the main global champion of free trade and this tendency accelerated markedly in the early 1990s (as the familiar chart below, sourced from Deutsche Bank, illustrates well).
The effect of free trade, per Ricardo, is to enlarge the global economic pie. However, in choosing free trade to enlarge the pie, each participating country voluntarily surrenders its ability to claim a larger slice of the pie, or a slice with particular toppings (in this analogy, choosing a particular slice means selecting the particular industries that you want your country to specialize in). Clearly, this is good in the long run – the size of your slice, and what you produce, is determined by your relative advantage in producing it and so the entire system produces the maximum possible output and the system collectively is better off. To the extent that a person is a citizen of the world, rather than a citizen of a particular country – and the Ricardian assumption is that increasing the pie is the collective goal – then free trade with every country producing only what they have a comparative advantage in is the optimal solution.
However, that does not mean that this is an outcome that each participant will like. Indeed, even in the comparative free trade of the late 1990s and 2000s, companies carefully protected their champion companies and industries. Even though the U.S. went through a period of being incredibly bad at automobile manufacturing, there are still several very large U.S. automakers. On the other hand, the U.S. no longer produces any apparel to speak of. In fact, the only way that free trade works for all in a non-theoretical world is if (a) all of the participants are roughly equal in total capability, and permanently at peace so that there is no risk that war could create a shortage in a strategic resource, or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself and/or to establish the conditions that ensure permanent peace by being the dominant military power and enforcing peace around the world. We would argue that (b) is what happened, as the U.S. was willing to let its own manufacturing be ‘hollowed out’ in order to make the world a happier place on average.
The President (and many of those who voted for him) feel that (b) is inherently unfair, or has reached extremes that are unfair to U.S. citizens. Essentially, the President is rejecting the theoretical Ricardian optimum and pursuing instead a larger slice for his constituents. This is where reciprocal tariffs (where the U.S. matches the tariff placed on its exports by a trading partner, with a tariff placed on the imports of that product from that trading partner) or blanket tariffs (where the U.S. imposes a tariff on all imports of a product irrespective of source – e.g. aluminum – or on all imports from a given trading partner) come in.
Blanket tariffs are good for domestic growth,[1] but definitely increase prices for consumers. How good they are for growth, and how much prices rise, depends on how easily domestic un-tariffed supply can substitute for the imported supply and also on whether your country is a net importer or exporter, and how large the export-import sector is in terms of GDP. Because this is an inflation outlook, let’s make a very rough estimate of the impact on the overall domestic price level of a blanket 20% tariff (such as the one Treasury Secretary Bessent has proposed). We suppose the average elasticity of import demand in the U.S. to be 3.33[2] and the elasticity of export supply to be 1.0[3]. In that case, the incidence of a tariff falls about 23% on consumers: [1.0 / (3.33+1.0) ]. So, for a 20% tariff, prices for the imported goods would be expected to rise about 4.6% (20% tariff x 23% incidence). However, imports only account for about 15% of US GDP, which means the effect on the overall price level would be 15% x 4.6% = 0.69%.
So, for a 20% blanket tariff on imports, Americans should expect to see a one-time increase in the overall price level of something on the order of 0.7%, smeared over the period of implementation. This is not insignificant, but it is also not calamitous. It does affect our estimates for 2025 and 2026 inflation, shown in the “Forecasts” section (somewhat less than 0.7%, because we do not expect a blanket tariff but rather reciprocal and targeted tariffs). Also note that the retaliatory tariffs on US exports have no direct effect on domestic prices, so that whether or not trading partners retaliate is irrelevant to an analysis of first round effects, anyway.
Thus my wild guess back in February was that a 20% blanket tariff would result in a bit less than 0.7%, smeared out over 2025 and 2026. That doesn’t answer the ‘timing’ question, but the delays in implementation (so as to not affect Christmas 2025 prices of the GI Joe with the Kung-Fu Grip) and the importer/retailer initial reaction to try and absorb as much as possible for optics – presumably, easing price increases into the system later – mean that it shouldn’t be shocking that we haven’t seen a big effect yet. My point in the above calculation, though, is that we really shouldn’t expect to see a big effect, regardless.
For what it’s worth, the Budget Lab at Yale estimates that currently “the 2025 tariffs to date are the equivalent of a 15.2 percentage point increase in the US average effective tariff rate,” so if we take my 0.7% guess for 20% then we would be looking closer to 0.5% in total. And in fact, lower even than that since the 15.2% average will have less impact than a 15.2% blanket tariff, assuming that the tariffs will be highest where domestic substitution is easier.[4]
Wrapping this up, let me make one final observation. Current year/year headline CPI inflation is 2.35%. The inflation swaps market, specifically the market for ‘resets’ where you can trade essentially the forward price level, currently suggests that traders expect y/y inflation to rise to 3.29% over the next six months: almost 1 full percentage point from here. But that actually flatters what the market is pricing, because the shape of the energy curves suggests that rise is being dragged about 20bps lower by the implied moderation in energy prices (give me a break, inflation traders: I’m doing this in my head).
So, the market is pricing core inflation peaking about 6 months from now, about 1.2% higher than it currently is. Not all of that is the effect of tariffs; some is due to base effects as the very low May, June, and July 2024 numbers roll off of the y/y figure. But if we get that result, you can be sure that economists will put most of the blame on Mr. Trump, while Mr. Trump will put most of the blame on Mr. Powell. Either way, I think the interest rate cuts that the President would prefer are unlikely unless growth takes a significant stumble.
[1] …but bad for global growth! There is no question that unilaterally applying tariffs to imports is bad for all suppliers/countries providing those imports. If Ricardo is right, the overall pie shrinks but the domestic slice gets larger…at least for the dominant players who already have a large slice. If everyone raises tariffs in a trade war outcome, the less-productive countries suffer the most loss of growth and the most-productive countries likely still benefit. But prices rise for all.
[2] Kee, Nicita, and Olarreaga, “Estimating Import Demand and Export Supply Elasticities”, 2004, Figure 5, available at http://repec.org/esNASM04/up.16133.1075482028.pdf Your answers may vary!
[3] Estimates are wildly all over the map, depending on the exporting country and the product. In general the smaller the country, the more price-inelastic it is. We chose unit elasticity here (a 1% increase in price cause a 1% increase in the quantity supplied) just to be able to get a rough guess.
[4] To be fair, the Budget Lab at Yale also estimates the effect on PCE inflation of a whopping 1.74%. They must be really surprised at the impact so far.
The Twin Deficits – One Out of Two IS Bad
From time to time on this blog, I circle back to the question of the balance of deficits. In my mind, as our economy goes through whatever the “Trump Transition” is, the biggest risk to the bond markets is not from some fear about whether the Treasury will default or whether the US dollar will cease to be the world’s currency of choice for reserves (neither of which I think is going to happen any time soon) but that large secular changes in the balances of savings and dollar demand could lead to outsized moves in interest rates.
First, let me remind you that the deficits are all intertwined. When the US Federal Government runs a deficit and borrows money, they have to get it from people/entities that have saved that money. One place that the government bond salesmen know they can turn to is non-US investors, who are in possession of those dollars because the US runs a large trade deficit with most other countries. When we run a trade deficit, it means we are importing more stuff than we are exporting or, equivalently, we are exporting more dollars than we are importing. Those dollars are pretty useless except to buy things that are dollar-denominated. By construction, we know that the new owners of dollars aren’t buying goods, because if they did there wouldn’t be a deficit; the main other thing they buy are securities or real property.
So if you don’t want other countries buying US stocks, buildings, and farmland, run a big trade surplus and they won’t have the dollars to do it.
It’s a good thing they have all of those dollars, because the Federal government needs them! The federal deficit needs to be funded by those foreign dollars, or by domestic savings (banks, individuals, companies, e.g.), or by the central bank buying up those bonds. And that’s pretty much it. Over time, the trade balance plus the budget balance plus the central bank balance plus private savings equals zero, more or less. During COVID, the massive expansion of the federal deficit was only possible because the Fed bought about the same number of bonds as the government sold. Had they not, interest rates would have risen precipitously because private savers would have had to be induced to put those dollars into bonds.
(Or, the government would give incentives for banks to hold more govvies, say by exempting them from the SLR. Not that such a thing would ever happen!)
Let’s pivot this then back to the Trump Transition. The stated goal of the Administration was to lower the trade deficit a lot, lower the budget deficit a lot, and lower interest rates. That all makes sense and is internally consistent. It could happen that way, if all of it happens that way.
What if, though, the President’s team makes more progress on one front than on the other? Early returns on the tariff front seem to imply that the US will face a smaller trade deficit going forward. Now, the latest spike higher (smaller deficit) here is at least partly and maybe mostly due to a ‘payback’ of the pre-tariff front-running that led to massive deficits in the prior three months. But it should not surprise us that increasing tariffs should cause the trade deficit to decline. That is, after all, sort of the point.
If we concede that the trade deficit is actually heading back towards some better semblance of balance, then that’s plank 1 of the Trump agenda. That will supply fewer dollars to cover the federal budget deficit, though. As long as the federal budget gets into something closer to balance…
That was the promise of DOGE, and of the revenues from tariffs. The latter will indeed be yuge, and will help balancing the budget. Or it would, if we weren’t about to run an even bigger deficit with the Big Beautiful Bill soon passing into law. The trailing-twelve-month budget deficit is just less than $2 trillion, which was a number we never even sniffed prior to COVID. So that’s the demand for savings: the feds look like they’re going to keep on spending more than they take in.
Unlike during COVID, too, the Fed is now letting its balance sheet shrink. No help there.
Now, there is also a movement in Congress to pass legislation preventing the Fed from paying interest on the reserves that banks hold at the Fed. For decades, the way the Fed managed the money supply was to adjust the quantity of reserves, which rationed credit and caused the price of credit (interest rates) to move as well. But it was the rationing of credit, not changing the price, that affected the money supply. Beginning with the Global Financial Crisis, the Fed flooded extra reserves into the system, forcibly deleveraging banks (look at that chart above again) – but, since that would also crush bank earnings, they started paying interest on reserves (IOR). Since, if banks were not being paid to hold reserves, they would hold as little as they could, the Fed had to pay interest or the excess of reserves in the overnight market would cause interest rates to always be zero. So the Fed started to manage the price of credit, rather than its quantity. The central bank fully intends to always hold way more in securities and therefore force way more reserves into the banks, going forward – but has gradually been reducing its portfolio securities. As I said, no help there.
If Congress succeeds in preventing the payment of IOR – and the politics on this looks good since the Fed now runs operating deficits, so that it is basically paying banks interest with taxpayer dollars (see chart below…Fed remits to the Treasury have dried up completely), then as I said above banks will try to hold fewer reserves and overnight interest rates will drop as banks compete to lend their excess reserves at anything above zero, unless (a) the fed increases the reserves banks are required to hold (really unlikely) or (b) the fed makes reserves scarce so some banks will have to buy them and some will sell them (the old way) (also really unlikely). In neither case does the Fed expand the balance sheet as a first intention, so unless we get another crisis the expansion of the Fed balance sheet is unlikely in my view.
So that leaves private savings. If the trade deficit declines and the budget balance doesn’t move significantly towards balance, then interest rates will have to rise, potentially a lot. I think the President’s stated plan makes very good economic sense. I just wonder if it’s going to be derailed by the desire to keep the Federal spend going.
Inflation Guy’s CPI Summary (April 2025)
Before the CPI analysis, I always try to give some context for where we are in the ‘story’ about the evolution of inflation right now. It’s really difficult to do that, though, because of all of the massive policy changes that are happening – and often in opposite directions with respect to the effect on inflation. Here is the Baker, Bloom & Davis Economic Policy Uncertainty Index, which is derived by scraping news sources. Even strong supporters of President Trump’s have to admit that his Administration has been a whirlwind on economic policy (for many of them, of course, that’s a feature and not a bug).
Here goes, anyway. Remember that last month, core CPI crashed but Median CPI actually accelerated. This kept us from actively celebrating the great inflation news; we knew that the good news was concentrated in a few one offs. In particular, Airfares (-5.3% for March), Lodging Away from Home (-3.5%), Used Cars (-0.69%), Car and Truck Rental (-2.66%), and Medicinal Drugs (-1.30%). But, as Median showed last month, there was really no reason to think that inflation was behind us…even before any effect from tariffs.
Speaking of tariffs, prior to this month we hadn’t really expected to see any effect yet and most economists thought that we shouldn’t see that much impact in the April figures either since the big tariffs on everyone went into place early in that month. However, remember that Mexico, Canada, and China had all faced escalating tariffs prior to April, so if there is going to be an impact we should expect to see something soon. I don’t expect a lot in most categories, but some impact in a few. It will be hard to discern how much of any monthly price change is tariffs, of course. We will look at Apparel, where demand elasticity in the short run is not terribly low. Broadly, though, remember that demand elasticity and foreign content percentage are both important…and foreign content in most goods is pretty low. I’d also look to Medicinal Drugs, since a lot of APIs are China-sourced and the demand for many drugs is pretty inelastic in the short-run, but I didn’t expect a lot of impact there (pharma companies will have had inventories), and going forward it will be muddied by Trump’s announcement of the Most-Favored-Nation policy in pharmaceuticals.
Speaking of that announcement, this month’s review of changes in inflation swap levels is seriously polluted because that announcement combined with the 90-day pause on China tariffs caused a massive crash in 1-year inflation expectations.
Despite the drop in tariff rates on China (for now), remember average tariffs remain the highest since the Great Depression (ominous music)! Of course, back then the US was a significant net exporter, so reciprocal tariffs were a bigger problem. Imports were only about 2-3% of GDP.
(Chart above is from https://www.stlouisfed.org/on-the-economy/2019/may/historical-u-s-trade-deficits)
(Chart above is from https://www.stlouisfed.org/on-the-economy/2020/march/evolution-total-trade-us)
There you go. That’s the context. Now onto the number.
CPI for April was expected to be +0.25%, and +0.27% on Core. The actual prints were 0.221% and 0.237%, respectively, so a mild surprise lower (although it turned the +0.3%/+0.3% rounded expectations to +0.2%/+0.2%, looking more dramatic a surprise than it actually was). Core is right about where it has been for the last 6 and 12 months (0.244% and 0.229% average, respectively) with the big January spike and the March plunge basically offsetting each other.
Amazingly, of the eight major subgroups only Housing, Medical Care, and “Other” increased on a m/m basis. What is especially surprising in that light is that Apparel – where the tariff canary in the coal mine lives – was down on the month.
Core goods continues to hook higher, now at +0.13% y/y. Remember, this is before any tariff effect has really been felt. In my mind, this is more the underlying ‘deglobalization’ effect: as I’ve said for a while, the deep deflation in core goods that we saw was a partial retracement of the COVID spike and we should expect going forward to see a small positive inflation in goods. Core services is decelerating nicely, and it will need to continue to do that if we’re ever going to see downward pressure in median inflation from where we are now.
Speaking of Median CPI, my early estimate is +0.308% m/m, putting the y/y at 3.43%. That’s about where we’ve been, and where we’re likely to be going forward.
Looking at some of those one-off categories from last month, Airfares fell another -2.83% m/m after that -5.3% prior decline. Some of that is jet fuel, some is tourism I suspect. Lodging Away from Home went flat (-0.1% m/m) from -3.54% prior. I think we’ll see continued downward pressure in that category, as hotels in some big cities are gradually emptied of illegal migrants and get added back to the stock of available rooms, but March’s drop was just too big. Used Cars’ decline (-0.53%) surprised some people, because the private surveys showed that prices advanced last month, but the seasonal assumption was a decent hurdle this month that wasn’t cleared. However, if you were worried about how the spike in car parts tariffs would cause car prices to spike…because that’s what the news was hyperventilating about…you needn’t have. New Car prices were also slightly down, -0.01% compared to +0.1% last month.
As for shelter, it continues to flatten out, with Primary Rents 3.98% y/y and OER at 4.31% y/y. Actually, Primary Rents were flat on a y/y basis compared to the prior month, and have basically converged with our model, which is around 3.7%. From here we should expect very slow deceleration, but rents should stay above 3.25% or so on a y/y basis.
Supercore is looking great. This is about the best news in the report, because if Shelter is just about tapped out and Core Goods is trending just above zero we’d need Core Services to continue to dive.
That’s the good news. The bad news is that the spread of median wages over median prices has returned to its long-run average, which means that it will be hard to see additional sharp declines here…it isn’t going to come from squeezing wages further.
Outright, the Atlanta Fed Wage Growth Tracker – the best measure of wages in my opinion – is at 4.3% y/y. That’s right where it was in November. It’s going to be very hard to squeeze services prices lower if wages don’t decelerate further.
Finally, let’s circle back to pharmaceuticals. I’m going to point you again to my article from 2020, which is the first time that the President mooted the idea of a Most-Favored-Nation clause affecting the pharmaceutical industry. https://inflationguy.blog/2020/08/25/drug-prices-and-most-favored-nation-clauses-considerations/ The upshot is that even if the MFN policy takes place exactly as the President states, retail drug prices are unlikely to decrease anything like as much as he has said. In fact, there could even be some circumstances in which drug prices rise because companies stop selling in foreign countries at levels lower than in the US (because they face a more-elastic demand there) but which contribute to the total profit of the drug company. There may be others in which the drug company stops selling the drug at all in the US. Furthermore, drug prices overall have only risen 7% since pre-COVID, compared to 23% for core prices generally (the black line in the chart below is the overall CPI for Medicinal Drugs; the blue is the core CPI price level – both normalized to December 2019).
By the way, if I was concerned about importing APIs from China and wanted the US to start producing more of them, I don’t think I’d be trying to crush end-product prices and reduce the incentive to spin up production of the APIs. So there will be a lot of exceptions to the MFN policy, and you can tell from the performance of pharma companies yesterday after the news (big up with the market, not down!) that investors don’t expect any important impact on the bottom lines of pharmaceutical companies. I agree. I think Medicinal Drugs going forward will probably decline a bit for some celebrated cases, but not in a big way that pushes CPI lower significantly.
The big conclusion here is that inflation continues to run at about 3.5% or so (Median), and there is no sign of a significant further deceleration to come. As long-time readers know, this has been my theme for a couple of years, that we will end up in the ‘high 3s, low 4s’ on median inflation, because the overall backdrop of deglobalization and demographics argue for a higher floor. If the Fed keeps money growth very low, my opinion could change (and I’d already amend my target to ‘mid to high 3s’ as the mode), but I am not very optimistic on that.
However, I also don’t think there is anything about the inflation picture that argues the Fed has a lot of room to drop rates significantly. I said last month “The right answer to uncertainty from a policymaker perspective is to increase the hurdle for taking action. The right answer is to make no changes to policy. I am not confident that the Federal Reserve will correctly separate the ‘price of risk’ effect from the ‘economic growth’ effect. They are correct to note that tariffs by themselves are not inflationary in that they are one-off effects. If they believe that, and they think there’s a big recession coming, they’ll cut rates. That would be a mistake, especially given the uncertainty.” I still think that’s the case. At the moment, there is no reason to cut rates any further than the ‘let’s help Biden’ cuts did, except to appease the President and I see little urgency from this Fed to do that. I wouldn’t expect any big moves from the Committee, any time soon.
One final announcement. If you’re an investor in cryptocurrencies (in particular, stable coins) and have a Telegram account, consider joining the read-only USDi_Coin room https://t.me/USDi_Coin where the USDi Coin price is updated every four hours or so…and where these charts are also posted shortly after CPI just as I used to do on Twitter before they changed the API to make auto-tweeting charts very difficult.
Trump Tactical Targeted Tariffs: A Reminder of the Impact of Tariffs
Representative Alexandria Ocasio-Cortez, aka AOC, recently railed against the President when he threatened Colombia with tariffs if they should refuse to accept their citizens being deported back to them. In her typical hyperventilated fashion, she implored us to “remember” that “WE pay the tariffs, not Colombia.”
For a change, AOC is not entirely wrong but merely mostly wrong. She seems to remember at least one important thing from Econ 101 and that is that businesses don’t pay anything to anyone, since a business is just a legal structure. Shareholders, other stakeholders, consumers, or suppliers pay and/or receive the cost of goods sold, taxes, wages, and so on. Unfortunately, I don’t think that was her point and she missed the important bit which is that ‘who pays the tariff’ depends almost entirely on the elasticity of demand for the product. Here are two charts. In each case, the tariff shifts the supply curve leftward/upward by the amount of the tariff, the same amount in both pictures. In each picture, the quantity consumed of the good being tariffed goes from c to d and the price goes from a to b as the market moves from one equilibrium to the other.
The first chart shows an inelastic demand curve, which is characterized by the fact that large changes in price do not change the quantity demanded very much. In this case, the main effect is that consumers buy almost as much of the good, but the price moves almost the full amount of the tariff. Consumers end up paying most of the tariff.
The second chart shows an elastic demand curve, in which even small changes in price induce large changes in the quantity demanded. In this case, the main effect is that consumers buy much less of the more-expensive good, and the price goes up only a little so that the seller bears most of the cost of the tariff.
Thus a blanket statement that “we pay the tariffs” is wrong. It is sensitive to the characteristics of the product market. One needs to be very careful about how we define the product market because it matters. I would argue that the elasticity of the demand for coffee is quite low, which is why Starbucks even exists. If the demand for coffee was very elastic, charging $5 a cup for bad coffee would not produce a line around the block at rush hour. But that is not what we are talking about here. The question here is, what is the demand elasticity for Colombian coffee? The answer to that question is very different. Coffee as a way to wake up in the morning has few close substitutes. But Colombian coffee has many, very very very close substitutes. My favorite right now is Ethiopian Yirgacheffe coffee. I also like a good Panama Boquete. Add 20% to the cost of the Boquete, and I think I’ll mostly drink the Yirgacheffe. Add 20% to both of them, and I’ll go to Brazilian Santos, or Colombian, or Kona.
I think the reaction of the Colombian President tells you everything you need to know about what he perceives about the demand for Colombian coffee and therefore the impact a tariff would have on exports of Colombian coffee to the United States. Trump very quickly got what he wanted with his Trump Tactical Targeted Tariffs (TTTT™). So to review: +1 for TTTT, -1 for AOC.
A couple of other points about tariffs and tariff strategy.
First, this episode illustrates a very important distinction to be made between the use of targeted tariffs and the use of blanket tariffs. Blanket tariffs, for example on everything we import from a major trading partner or on every trading partner, definitely increase prices for consumers. How much, and which prices, depends on how easily domestic untariffed supply can substitute for the imported supply. But the answer is certainly that prices go up. But let me point you to two articles I’ve written previously about this:
Tariffs Don’t Hurt Domestic Growth (https://inflationguy.blog/2019/08/28/tariffs-dont-hurt-domestic-growth/), August 28, 2019. This is a really good piece. In summary, tariffs are bad for global growth but they are not the unalloyed negative you learned about in school. How good/bad they are for growth depends on whether you are a net importer or a net exporter, and how large the Ex-Im sector is in your country. Truly free trade works in a non-theoretical world only if “(a) all of the participants are roughly equal in total capability or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself.” Really, you should read this.
The Re-Onshoring Trend and the Long-Term Impact on Core Goods (https://inflationguy.blog/2022/02/22/the-re-onshoring-trend-and-the-long-term-impact-on-core-goods/) February 22, 2022. This is not directly about tariffs, but the broad imposition of tariffs (if they happen) should be thought of as reinforcing this prior trend. The prior trend, of re-onshoring production to the US, has been under way for several years – the way that COVID exposed long supply lines certainly helped the trend but the long-term globalization trend was already reversing and in this article I argue that this means core goods inflation going forward is likely to be small positive, rather than persistently in deflation. In the context of the current discussion, President Trump has certainly made re-onshoring of production a major goal of his Administration. So whether it happens because of TTTT, or because of blanket tariffs, or because of tax breaks given for domestic production, the direction of the inflation arrow is clear.
I’m not worried about hyperinflation from tariffs and I think that if you’re the biggest and the strongest economic actor they’re probably more good than bad for domestic economic outcomes.
Reality is more nuanced than we learned in school. Not everything that expands the economy is good, and not everything that is good expands the economy. Not everything that is bad causes inflation to go up, and not everything that causes inflation to go up is bad.
The Re-Onshoring Trend and the Long-Term Impact on Core Goods
I know that today, and probably for a little while, investors are focused on Ukraine and Russia. I am gratified that for what seems the first time in many years, notes about the conflict tend to include some form of the addendum “and its effect on domestic inflation,” albeit in many cases this is from the perspective of how this engagement will damage or burnish President Biden’s poll numbers at home and the prospects for his party in the midterm elections. How self-absorbed we Americans are! To be fair, in my opinion the importance of the US policy-response operetta was always less about Ukraine than about Taiwan. I hope that doesn’t turn out to be right.
However, today I want to talk about the re-onshoring trend in manufacturing, and the significance of this for inflation going forward.
One of my 2022 themes so far is that the conventional expectation for inflation to peak soon and ebb to a gentle 2% over the next 12-18 months is mostly predicated on the idea that the extraordinary spikes we have seen in certain categories (see: motor vehicles) will eventually pass, and inflation will return to the underlying trend. The simpler observers see it as 12 months since (mechanically) the spikes will all be out of the y/y number in 12 months. Some forecasters are giving themselves a little wiggle-room by saying it will take 18 months as the ports unclog and ‘other knock-on effects’ wash through. But in my opinion, the evidence is strong that the underlying trend is no longer 2%, but more likely 3-4% or higher. Part of that evidence is the great breadth that we have seen in the recent inflation numbers, which suggests either a riot of unfortunate coincidental events all in the same direction, or else a common cause…say, the rapid growth rate of the money supply, which as of the latest report is still growing more than 12% annualized over the last quarter, half-year, and year.
The forecasts of sharply decelerating inflation expect the parade of “one off” causes to end – and, crucially, to be replaced by unbiased random events that are equally likely to be up or down. This is ‘assuming a can-opener,’ and is economist malpractice in my opinion. Because of the continued rapid growth of money, and until that rapid growth slows drastically or reverses, the surprises are mostly going to be on the high side. That’s why I expect inflation to be lower at the end of the year than it is right now, but not lots lower.
All of this, though, obfuscates a trend that had started prior to COVID but has gained great momentum since. When President Trump was first elected, we’d suggested in our customer Quarterly Inflation Outlook that one of the following winds which had kept inflation low despite loose monetary policy throughout the 1990s and 2000s was in the process of stopping and potentially reversing. That following wind was globalization. I eventually ended up talking a lot about de-globalization. Here’s one article from four years ago. I really love the Deutsche Bank chart in it.
In a nutshell, the argument was that domestic goods prices had been kept abnormally low despite strong economic growth and loose monetary policy through the prior quarter-century because businesses had gradually over time offshored production and extended raw materials and intermediate-goods supply chains to cheaper manufacturing locations outside of our borders. But that’s a trick that can only be turned once. When most production is overseas and most intermediate goods imported from the Pacific Rim, costs will resume rising at the rate of inflation in the source country, adjusted for FX changes. For decades, we’d seen core goods inflation near zero despite services inflation in the 2-4% range, as this dynamic played out, but there was no reason that goods inflation should permanently be zero.
So I thought that in 2016 we were already coming slowly to a point where similar monetary policy going forward was going to result in less growth and more inflation because that trick had been used up. The election of President Trump merely accelerated that timeline and increased the probability that the trend wouldn’t only stop but could reverse, causing the division of growth and inflation for a given monetary policy to be distinctly bad and requiring much tighter policy.
COVID-19, and the global response to COVID-19, has more or less totally reversed the arrow of global trade. Businesses are pulling manufacturing back to the US and pulling supply chains back to the Western Hemisphere as much as possible. Geopolitical tensions between the US and Russia, and the US and China, combined with the increased appreciation of the optionality of inventories and the cost imposed by long and variable lead times, which is partly reflected in the need to hold more inventory. And that, in turn, drastically decreases the attractiveness of a long supply chain, especially with global tensions, the rise of democratic populism (“we want what’s ours, not some global citizenship award!”), and the persistent rise in energy and other costs of transportation (driver shortages, etc).
All of which arguments I’ve made before. But I’m not sure I’ve drawn the line clearly enough that the net effect of this changing dynamic – which results in manufacturers choosing higher costs rather than lower costs – is that goods inflation is unlikely in my view to return to being centered around zero. While core services are a bigger chunk of the consumption basket than are core goods, that’s mostly because of shelter services. Core goods is 22% of the consumption basket; core services (less rent of shelter) is 25%. So this is not something that can be idly dismissed. If the mean of the distribution moves from 0% to just 3%, that moves the “normal” level of inflation up ~0.66%. Obviously, I think in the medium-term the number is a lot larger than that, but the key is whether the effect is going to be persistent over a long period of time (think years or decades, not months). I believe it will far outlast COVID, because the causes go far beyond COVID.
The Political Temptation Posed by “Price Gouging”
The arc of explanations about the rise in inflation and the end of the disinflationary era was foreordained:
- There’s no inflation.
- What you’re calling inflation is just a series of one-offs.
- This is just a ‘transitory’ phenomenon, a one-off at the broad economy level, and will soon fade.
- “It’s actually okay.” (NY Times: Inflation Could Stay High Next Year, and That’s OK)
- It’s greedy manufacturers and vendors that are price-gouging. Where is my pitchfork?
In the current arc, we are already easing past level 3, as “transitory” is starting to be stretched a bit to “well, not past 2022” (Former Fed Chair Ben Bernanke opined yesterday at an online event that inflation would “moderate” in 2022). And we’ve seen signs of #4, and even some #5. The blame game is heating up, and with an Administration under pressure for its handling of…well, everything…I suspect we will move sooner rather than later into the full-blown level 5, complete with price controls in some industries and possibly economy-wide. Yes, there’s a very clear lesson from history that price controls don’t work to restrain inflation, but (a) today’s politicians don’t seem to really know much history, and (b) price controls need not be about restraining inflation – for some, it’s worth the political points.
Since it’s a term we will hear more of, I thought I’d try and put a little more structure around the accusation of “price gouging.” It is an easy term to throw around, but what does it mean?
Developed economies are still mostly free markets, in that buyers and sellers are given wide latitude to negotiate on price and quantity. In certain markets, where there are limitations on competition (electric utilities being a classic example) or vast differences in negotiating power or information (health insurance?) there are limits on the terms of trade but for the most part, if you want to buy an apple from the apple vendor you can strike whatever deal suits you both. In a free market, either the buyer or the seller can choose not to transact at the proffered price; ergo, economists assume that if a transaction occurs then both buyer and seller made themselves better off or at least not worse off. Unlike many economist assumptions, this one doesn’t seem like a bad one, at least in most cases.
If the price is “too high” for the buyer, then the buyer can complain but the buyer can always choose to not transact. So there’s only two senses in which “price gouging” might mean something:
- The price is egregiously high because the seller knows you really have no alternative, as the buyer, other than to buy. If there is a mandate to buy insurance or lose your liberty, but no cap on the price of insurance, then the insurance provider can charge any price it wants. This is infrequent. Arguably, in the aftermath of hurricanes it might apply to building materials, but even in that case I would argue #2 below is a more-accurate sense of the word.
- The price is, in some sense, “unfair.”
What is “unfair?” We do, as social animals, have some innate sense of fairness. A classic result from “the ultimatum game,” where one person is endowed with money that he/she chooses unilaterally how to split with a second person who can in turn accept the split or reject it (in which case both parties get nothing) is that under experimental conditions splits that are worse than 70:30 tend to be rejected by the responding party – in other words, the respondent would rather get zero than 30%, if it feels “unfair.” It is in that context that “price-gouging” accusations could be related to “anchored” inflation expectations. If a vendor is charging a very high price, but the buyer expects price changes to be large, volatile, and generally not in the buyer’s favor, then an accusation of “price gouging” is less likely than if the buyer expects price changes to be low and random. So, it might be that accusations of price gouging simply means that the buyers have not adjusted to a new inflation/pricing paradigm, and perceive the price increases as unfair even if they are objectively fair.
If that’s the case, then the buyer is going to lose in cases where the higher prices are a result of changes in the supply/demand balance. Higher prices are how limited supply gets rationed among the buyers – it is a feature, not a bug, of the capitalist system. In the case where a surge in demand (caused by, say, massive government transfers to consumers) causes stock-outs and rising prices, then accusations of price gouging are just sour grapes. Rising prices in this case are simply normal inflation happening in an environment that has not adapted to normal inflation again. (Listen to the Inflation Guy Podcast, episode 2, where I point out that “supply chain problems” is exactly what inflation caused by too much money looks like.)
Nevertheless, where the “price gouging” accusation is code for “this feels unfair,” it is a terrific opportunity for a political lever. Politicians will feel that they can make people happy by instituting price controls, and blaming the wealthy industrialist, even though economics and history tell us that this isn’t the right answer. But it is a siren song, and I think that we are very likely to start hearing this more and more.
Once price controls are instituted, what follows is that the stock market craters (since the difference between input costs and consumer prices is some part profit), a black market develops in the restricted goods and services, and many products get impossible to acquire or rationed by a lengthening waitlist rather than by price.
Can you really control prices in the Internet age? It hardly matters. Politicians don’t really care about controlling prices after all; they merely want to appear as if they’re on the side of the voters. Bashing suppliers is one easy way to do that. I don’t think it will be long now. Keep the torches and pitchforks at the ready.
Drug Prices and Most-Favored-Nation Clauses: Considerations
A potentially important development in the market for pharmaceuticals – and in the pricing of the 1.6% of the Consumer Price Index that Medicinal Drugs represents – is the President’s move towards a “most-favored-nation” clause in the pricing of pharmaceuticals. The concept of a favored-nations clause is not new, although this is the first time it has been applied broadly to the pharmaceutical industry. In the investment management industry, it is not uncommon for very large investors (state pension funds, for example) to demand such a clause in their investment management agreements. Essentially, what such a clause does is guarantee to the customer that no other customer will get better pricing.[1] In the context of pharmaceuticals, the “problem” that the President is addressing is the fact that Americans buying a drug will often pay many times what a customer in another country will pay the pharmaceutical company for that same drug.
The optics are terrific for the President, but the economics not as much so. The argument is that demanding such a clause will force pharmaceutical companies to lower prices for American consumers drastically, to something approximating the price of those same products purchased abroad. The reality, though, is not so clear.
This is a story about price elasticity of demand. As I do often, I pause here and give thanks that I studied economics at a university that had a fantastic econ faculty. Economics is a great field of study, because done right it teaches a person to ask the right questions rather than jumping to what seems to be the apparent answer. (Incidentally, I feel the same way about Street research: done right, the value of that research is in guiding the questions, rather than handing us the answers.)
So let’s start at the ‘free market’ version of the pharmaceutical company’s profit-maximization problem. Let’s start by assuming that the marginal cost of production of a little pill is close to zero, or at least that it’s no different for the pill sold in one country versus the pill sold in another country. Then, the firm’s profit-maximizing linear programming problem is to maximize, independently for each country, the price where the marginal revenue is essentially zero – where in order to sell additional units, the price must be lowered enough that selling those additional units costs more in lost profit on the other units than it does on the incremental units. (If I sell 10 units at $10, and in order to sell the 11th unit I have to lower the price to $9, then I go from $100 in revenue to $99 in revenue and so if I am a profit-maximizer I won’t do this).
This point will be different in each country, and depends on the demand elasticity for that drug in that country. If the demand for a drug is very elastic, then that market will tend to clear at a lower price since each incremental decline in price will produce a relatively large increase in incremental quantity demanded. On the other hand, if the demand for the drug is very inelastic, then that market will tend to clear at a higher price since each additional increase in price will result in the loss of relatively few units of quantity sold. Now, every country and every drug will have different price elasticities. A lifestyle drug like the little blue pill will face fairly elastic demand in a Third World country, while a malarial drug probably does not.[2]
As an aside, one of the things which creates a more-elastic demand curve is the availability of substitutes. So, if the FDA makes it more difficult for a new statin drug to be approved than does the equivalent agency in Italy, then demand for a particular statin drug (all else equal) will be more elastic in Italy, where it faces more competition, than in the US. If you want lower prices, promote competition. But back to our story:
Now the Trump Administration adds a constraint to the drug company’s linear programming problem, such that the maximization is now joint; the problems are no longer independent maximization problems but the company must find the price that maximizes revenue across all markets collectively. If the free market has found a perfect and efficient equilibrium, then any such constraint must lower the value of the revenue stream to the drug company because if it did not, then it implies the company would already have be operating at that single-price solution. Constrained solutions can never be more valuable than unconstrained solutions, if both are in equilibrium.
What the drug company most assuredly will not do, though, is immediately lower the price to the American consumer to the lowest price charged to any other country. What it will do instead is take the highest price, and then add the incremental market that has the most inelastic demand, and see how much total revenue will increase if they have to lower the universal price to induce demand in that market. Note that this outcome may lower the price in the high-priced country, but it will also raise the price in the low-priced country. Since the lower-priced countries probably have more-elastic demand than the high-priced country…which is suggested by the fact that they had lower prices when they were being separately optimized…it is easy to imagine a scenario where the drug company ends up only supplying the high-priced country because the large increases in price for other countries essentially eliminate that demand. And that outcome, or indeed as I said any constrained outcome, is likely to be bad for the drug company. But what it will almost certainly not do is cause drug prices in the USA to drop 70%, or a massive decline in the Medicinal Drugs portion of CPI.
It may cause a decline in US drug prices, but that is not as certain as it appears. If the optimal strategy is to supply the drug only in the United States, then prices need not change at all (the US would then be the Most Favored Nation because it’s the only customer). In fact, the drug company might need to increase prices in the US. That happens because when you allow price discrimination, any customer who pays more than the variable cost of the product (which we assume here is close to zero) contributes something to the fixed overhead of the company;[3] therefore, a company that understands cost accounting will sometimes sell a product below the total cost per unit as long as it is above the variable cost per unit. When a US company, then, sells a pill to Norway at a really low price but above the cost of production, it defrays some of its overhead. If a most-favored-nation clause prevents a company from doing this, it will need to raise the price of the product in its remaining markets in order to cover the overhead that is not being covered any longer by those customers.
OK, so that’s just one iteration. I suspect that most pharmaceutical companies will end up lowering prices a little bit in the US and in other countries where prices are similar, and only selling them in countries that now pay a very low price to the extent that those foreign countries and/or international charities subsidize those purchases. But then we get into the financial and legal engineering part of this: what happens if Pfizer now licenses the formula for a particular drug to an Indian company that is legally distinct and doesn’t sell to the United States? Does the licensing agreement also fall under the MFN clause? What if Pfizer spins off its South American operations, sharing the intellectual property with its spinoff? For that matter, it might be the case that for some drugs, it is optimal to sell it everywhere in the world except the US, because the value of the unconstrained-non-US portion of the business is greater than the constrained-US portion of the business.
Now wouldn’t that be a kick in the head, to see pharmaceutical companies leave the US and refuse to sell to the US consumer because it makes them subject to the MFN clause? In the end, it seems to me that this is a great political gesture but it will be very difficult to get the results the President and his team wants.
[1] As an aside, in investment management this has caused the universe of strategies available to institutions demanding this clause to be reduced, hurting their investors. There are many circumstances in which an investment manager will offer outstanding, and sometimes outlandish, terms to investors who are the first in a new strategy, or who are low-touch easy/sophisticated customers, etc; a later entry by a large, high-maintenance customer may not be economic under the same terms.
[2] I am not at all an expert on how drug price elasticity behaves in this riot of market/product combinations, so readers who are should give me a break! I’m just illustrating a point.
[3] Cleverly called “variable contribution.”
COVID-19 in China is a Supply Shock to the World
The reaction of much of the financial media to the virtual shutdown of large swaths of Chinese production has been interesting. The initial reaction, not terribly surprising, was to shrug and say that the COVID-19 virus epidemic would probably not amount to much in the big scheme of things, and therefore no threat to economic growth (or, Heaven forbid, the markets. The mere suggestion that stocks might decline positively gives me the vapors!) Then this chart made the rounds on Friday…
…and suddenly, it seemed that maybe there was something worth being concerned about. Equity markets had a serious slump yesterday, but I’m not here to talk about whether this means it is time to buy TSLA (after all, isn’t it always time to buy Tesla? Or so they say), but to talk about the other common belief and that is that having China shuttered for the better part of a quarter is deflationary. My tweet on the subject was, surprisingly, one of my most-engaging posts in a very long time.
It has been so long since we have seen a supply shock that we have forgotten what they look like. China Inc shutting down is a supply shock. Supply shocks are inflationary, not disinflationary. Carry on.
— Michael Ashton (@inflation_guy) February 24, 2020
The reason this distinction between “supply shock” and “demand shock” is important is that the effects on prices are very different. The first stylistic depiction below shows a demand shock; the second shows a supply shock. In the first case, demand moves from D to D’ against a stable supply curve S; in the latter case, supply moves from S to S’ against a stable demand curve D.
Note that in both cases, the quantity demanded (Q axis) declines from c to d. Both (negative) demand and supply shocks are negative for growth. However, in the case of a negative demand shock, prices fall from a to b; in the case of a negative supply shock prices rise from a to b.
Of course, in this case there are both demand and supply shocks going on. China is, after all, a huge consumption engine (although a fraction of US consumption). So the growth picture is unambiguous: Chinese growth is going to be seriously impacted by the virtual shutdown of Wuhan and the surrounding province, as well as some ports and lots of other ancillary things that outsiders are not privy to. But what about the price picture? The demand shock is pushing prices down, and the supply shock is pushing them up. Which matters more?
The answer is not so neat and clean, but it is neater and cleaner than you think. Is China’s importance to the global economy more because of its consumption, as a destination for goods and services? Or is it more because of its production, as a source of goods and services? Well, in 2018 (source: Worldbank.org) China’s exports amounted to about $2.5trillion in USD, versus imports of $2.1trillion. So, as a first cut – if China completely vanished from global trade, it would amount to a net $400bln in lost supply. It is a supply shock.
When you look deeper, there is of course more complexity. Of China’s imports, about $239bln is petroleum. So if China vanished from global trade, it would be a demand shock in petroleum of $240bln (about 13mbpd, so huge), but a bigger supply shock on everything else, of $639bln. Again, it is a supply shock, at least ex-energy.
And even deeper, the picture is really interesting and really clear. From the same Worldbank source:
China is a huge net importer of raw goods (a large part of that is energy), roughly flat on intermediate goods, and a huge net exporter of consumer and capital goods. China Inc is an apt name – as a country, she takes in raw goods, processes them, and sells them. So, if China were to suddenly vanish, we would expect to see a major demand shock in raw materials and a major supply shock in finished goods.
The effects naturally vary with the specific product. Some places we might expect to see significant price pressures are in pharmaceuticals, for example, where China is a critical source of active pharmaceutical ingredients and many drugs including about 80% of the US consumption of antibiotics. On the other hand, energy prices are under downward price pressure as are many industrial materials. Since these prices are most immediately visible (they are commodities, after all), it is natural for the knee-jerk reaction of investors to be “this is a demand shock.” Plus, as I said in the tweet, it has been a long time since we have seen a serious supply shock. But after the demand shock in raw goods (and possibly showing in PPI?), do not be surprised to see an impact on the prices of consumer goods especially if China remains shuttered for a long time. Interestingly, the inflation markets are semi-efficiently pricing this. The chart below is the 1-year inflation swap rate, after stripping out the energy effect (source: Enduring Investments). Overall it is too low – core inflation is already well above this level and likely to remain so – but the recent move has been to higher implied core inflation, not lower.
Now, if COVID-19 blossoms into a true global contagion that collapses demand in developed countries – especially in the US – then the answer is different and much more along the lines of a demand shock. But I also think that, even if this global health threat retreats, real damage has been done to the status of China as the world’s supplier. Although it is less sexy, less scary, and slower, de-globalization of trade (for example, the US repatriating pharmaceuticals production to the US, or other manufacturers pulling back supply chains to produce more in the NAFTA bloc) is also a supply shock.
A Generous Fed Isn’t Really the Good News it Sounds Like
I understand why people are delighted about Powell’s remarks yesterday, about how the Fed would need to see a significant and sustained increase in inflation before hiking rates again. This generation, and the last, does not see inflation as a significant threat, nor a significant cost should it get going, and believes firmly that the Fed can easily squelch it if it gets going. (They believe this because, after all, the Fed told them so).
Older investors might be more reticent to believe that there’s a pony in there somewhere, since the evidence suggests that not only does inflation erode purchasing power (thereby demanding even more nominal return be provided by portfolios that are already overstretched valuation-wise) but it also ruins the diversification effect of bonds relative to stocks. The main reason that 60:40 is a dramatically lower risk portfolio (and more efficient in an investing sense) than 100% stocks is that stock and bond returns have tended to be inversely correlated for a long time. When stocks go up, bonds go down, in general (and vice-versa). But that’s because they have inverse sensitivities to the economic growth factor. In recent years, that has been the only factor that matters, but stocks and bonds have the same sensitivity to the inflation factor: when inflation goes up, both stocks and bonds tend to decline (and vice-versa). Consequently, when inflation becomes an important element in investors’ calculations the correlation of stocks and bonds tends to be positive and in the immortal words of Billy Joel in “Goodnight Saigon,” “We would all go down together.” Along these lines I recently prepared this chart for Real Asset Strategies,[1] illustrating that when inflation is over about 2.5%, correlations tend to flip. This is a 3-year average of y/y inflation (and shown on the chart as inflation minus 2.5% so the zero line is what matters, not the line at 2.5%) versus 3-year correlations; the point is that you don’t need 4% inflation to drastically change the value of the 60:40 portfolio.
I also think that people give the Fed much more credit for their ability to squelch inflation – which after all they haven’t had to do for more than 30 years after spending 15 years squelching the last round – than they deserve. But that’s a ‘show me’ situation and it’s hard to prove my suspicion that they won’t be so successful when push comes to shove.
So, I understand why people are partying about a Fed that is even looser than it had been. I don’t think that’s the correct response, but I understand it.
I also understand why people are somewhat morose about trade frictions. It isn’t for the right reason, that in the long run it will hurt real growth a smidge and increase inflation a smidge-and-a-half, but because they think it will have a drastic effect on near-term growth. That’s why everyone gets so excited about any inkling the US and China are nearing a trade détente and so depressed when it looks like they aren’t. We are told that the current global slowdown is being caused largely by the trade war.
In my view that’s nonsense. The global economy has been expanding for a decade on exceptionally loose liquidity but no tree grows to the sky. The global economy was slowing well before the trade frictions could possibly have had any impact. But it is hard to convince people of that, because everyone knows that:
GDP = C + I + G + (X-M),
or consumption plus investment plus government spending plus trade. And we learned in school about Ricardian comparative advantage and how trade enriches (or anyway, can enrich) both parties at the same time. So if China doesn’t import anything from the US and doesn’t export anything to the US, growth is going to be crushed, right?
But that’s not how trade works. Frankly, that’s not how anything in the GDP equation works. If you remove the final term, you don’t reduce GDP by (X-M). Sure, if this was an algebra problem you would, but it’s not. In the real world, what you lose from trade gets partially replaced by an increase in consumption, investment, or government. Just as I pointed out last year with soybeans, if China buys zero from us it means they have to buy them from someone else, which means that supplier doesn’t have them to sell to one of their traditional customers…who then buys them from us. Incidentally, neither beans nor corn went to zero after mid-2018 (see chart, source Bloomberg, normalized to December 2017=100).
The rest of trade works the same way if the two parties are “internal customers” and “external customers.” Though there will always be winners and losers, if we don’t have international trade then we won’t have a destination for our merchandise overseas…but we will also have consumers who don’t have Chinese goods to buy and so need to buy something from a domestic producer instead. This is not a zero sum game; it clearly results in a loss for all players. But the order of magnitude of this loss in the short run is not very big at all, especially for a country with a large fraction of its domestic production going to domestic consumption, as in the US but not even for the world at large. The world economy has lots of reasons to slow and go into recession, and trade frictions are one of those reasons, but certainly not the only one and not even the largest reason.
An overreaction by markets to anything in a stream of economic news is not unique or new, of course; those overreactions won Robert Shiller a Nobel Prize after all for his work pointing out the “excess volatility puzzle” as an early highlight of the nascent field of behavioral economics. But there’s a good reason to ignore most of these wiggles and focus on the long-term effect of these developments. Which, in the case of both the general climate of trade and the Fed’s reaction function to inflation, are negatives for both stocks and bonds.
[1] As part of Enduring Intellectual Properties’ investment in Real Asset Strategies, I serve as Director of Research for the firm. Real Asset Strategies LLC offers liquid real asset strategies focused on diversification benefits and inflation protection at reasonable fees.
Tariffs Don’t Hurt Domestic Growth
I really wish that economics was an educational requirement in high school. It doesn’t have to be advanced economics – just a class covering the basics of micro- and macroeconomics so that everyone has at least a basic understanding of how an economy works.
If we had that, perhaps the pernicious confusion about the impact of tariffs wouldn’t be so widespread. It has really gotten ridiculous: on virtually any news program today, as well as quite a few opinion programs (and sometimes, it is hard to tell the difference), one can hear about how “the trade war is hurting the economy and could cause a recession.” But that’s ridiculous, and betrays a fundamental misunderstanding about what tariffs and trade barriers do, and what they don’t do.
Because to the extent that people remember anything they were taught about tariffs (and here perhaps we run into the main problem – not that we weren’t taught economics, but that people didn’t think it was important enough to remember the fine points), they remember “tariffs = bad.” Therefore, when tariffs are implemented or raised, and something bad happens, the unsophisticated observer concludes “that must be because of the tariffs, because tariffs are bad.” In the category of “unsophisticated observer” here I unfortunately have to include almost all journalists, most politicians, and most alarmingly a fair number of economists and members of the Fed. Although, to be fair, I don’t think the latter two groups are making the same error as the former groups; they’re probably just confusing the short-term and the long-term or thinking globally rather than locally.
In any event, this reached a high enough level of annoyance for me that I felt the need to write this short column about the effects of tariffs. I actually wrote some of this back in June but needed to let it out again.
The effect of free trade, per Ricardo, is to enlarge the global economic pie. (Ricardo didn’t speak in terms of pie, but if he did then maybe people would understand this better.) However, in choosing free trade to enlarge the pie, each participating country surrenders its ability to claim a larger slice of the pie, or a slice with particular toppings (in this analogy, choosing a particular slice means selecting the particular industries that you want your country to specialize in). Clearly, this is good in the long run – the size of your slice, and what you produce, is determined by your relative advantage in producing it and so the entire system produces the maximum possible output and the system collectively is better off.
However, that does not mean that this is an outcome that each participant will like. Indeed, even in the comparative free trade of the late 1990s and 2000s, companies carefully protected their champion companies and industries. Even though the US went through a period of truly sucking at automobile manufacturing, we still have the big three automakers. On the other hand, the US no longer produces any apparel to speak of. In fact, I would suggest that the only way that free trade works at all in a non-theoretical world is if (a) all of the participants are roughly equal in total capability or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself. Many would argue that (b) is what happened, as the US was willing to let its manufacturing be ‘hollowed out’ in order to make the world a happier place on average. Enter President Trump, who suggested that as US President, it was sort of his job to look out for US interests. And so we have tariffs and a trade war.
What is the effect of tariffs?
- Tariffs are good for the domestic growth of the country imposing them. There is no question about it in a static equilibrium world: if you raise the price of the overseas competitor, then your domestic product will be relatively more attractive and you will be asked to make more of it. If other countries respond, then the question of whether it is good or bad for growth depends on whether you are a net importer or exporter, and on the relative size of the Ex-Im sector of your economy. The US is a net importer, which means that even if other countries respond equally it is still a gain…but in any event, the US economy is relatively closed so retaliatory tariffs have a comparatively small effect. The effect is clearly uneven, as some industries benefit and some lose, but tariffs are a net gain to growth for the US in the short term (at least).
- Tariffs therefore are good for US employment. In terms of both growth and employment, recent weakness has been blamed on tariffs and the trade war. But this is nonsense. The US economy and the global economy have cycles whether or not there is a trade war, and we were long overdue for a slowdown. The fact that growth is slowing at roughly the same time tariffs have been imposed is a correlation without causality. The tariffs are supporting growth in the US, which is why Germany is in a recession and the US is not (yet). Anyone who is involved with a manufacturing enterprise is aware of this. (I work with one manufacturer which has suddenly started winning back business that had previously been lost to China in a big way).
- Tariffs are bad for global growth. The US-led trade war produces a shrinkage of the global pie (well, at least a slowing of its growth) even as the US slice gets relatively larger. But for countries with big export-import sectors, and for our trade partners who are net exporters to the US and have tariffs applied to their goods, this is an unalloyed negative. And as I said, more-fractious trade relationships reduce the Ricardian comparative advantage gain for the system as a whole. It’s just really important to remember that the gains accrue to the system as a whole. The question of whether a country imposing tariffs has a gain or a loss on net comes down to whether the growth of the relative slice outweighs the shrinkage of the overall pie. In the US case, it most certainly does.
- Trade wars are bad for inflation, everywhere. I’ve written about this at length since Trump was elected (see here for one example), and I’d speculated on the effect of slowing trade liberalization even before that. In short, the explosion of free trade agreements in the early 1990s is what allowed us to have strong growth and low inflation, even with a fairly profligate monetary policy, as a one-off that lasted for as long as trade continued to open up. That train was already slowing – partly because of the populism that helped elect Mr. Trump, and partly because the 100th free trade agreement is harder than the 10th free trade agreement – and it has gone into reverse. Going forward, the advent of the trade war era means we will have a worse tradeoff of growth and inflation for any given monetary policy. This was true anyway as the free-trade-agreement spigot slowed, but it is much more true with a hot trade war.
- Trade wars are bad for equity markets, including in the US. A smaller pie means smaller profits, and a worse growth/inflation tradeoff means lower growth assumptions need to be baked into equity prices going forward. Trade wars are of course especially bad for multinationals, whose exported products are the ones subject to retaliation.
In the long run, trade wars mean worse growth/inflation tradeoffs for everyone – but that doesn’t mean that every country is a net loser from tariffs. In the short run, the effect on the US of the imposition of tariffs on goods imported to the US is clearly positive. Moreover, because the pain of the trade war is asymmetric – a country that relies on exports, such as China, is hurt much more when the US imposes tariffs than the US is hurt when China does – it is not at all crazy to think that trade wars in fact are winnable in the sense of one country enlarging its slice at the expense of another country or countries’ slices. To the extent that the trade war is “won,” and the tariffs are not permanent, then they are even beneficial (to the US) in the long run! If the trade war becomes a permanent feature, it is less clear since slower global growth probably constrains the growth of the US economy too. Permanent trade frictions would also produce a higher inflation equilibrium globally.
In this context, you can see that the challenge for monetary policy is quite large. If the US economy were not weakening anyway, for reasons exogenous to trade, then the response to a trade war should be to tighten policy since tariffs lead to higher prices and stronger domestic growth. However, the US economy is weakening, and so looser policy may be called for. My worry is that the when the Federal Reserve refers to the uncertainty around trade as a reason for easing, they either misapprehend the problem or they are acting as a global central bank trying to soften the global impact of a trade war. I think a decent case can be made for looser monetary policy – but it doesn’t involve trade. (As an aside: if central bankers really think that “anchored inflation expectations” are the reason we haven’t had higher inflation, then why are they being so alarmist about the inflationary effects of tariffs? Shouldn’t they be downplaying that effect, since as long as expectations remain anchored there’s no real threat? I wonder if even they believe the malarkey about anchoring inflation expectations.)
Do I like tariffs? Well, I don’t hate them. I don’t think the real economy is the clean, frictionless world of the economic theorists; since it is not, we need to consider how real people, real industries, real companies, and real regimes behave – and play the game with an understanding that it may be partially and occasionally adversarial, rather than treating it like one big cooperative game. There are valid reasons for tariffs (I actually first enumerated one of these in 1992). I won’t make any claims about the particular skill of the Trump Administration at playing this game, but I will say that I hope they’re good at it. Because if they are, it is an unalloyed positive for my home country…whatever the pundits on TV think about the big bad tariffs.
