Macroeconomic Impacts of Tariffs and Federal Reserve Policy

Our US public policy and global economics experts discuss how an escalation of US tariffs could have major domestic and international economic implications.

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Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore, Morgan Stanley's US Public Policy Strategist.

Arunima Sinha: And I’m Arunima Sinha, from the Global Economics team.

Ariana Salvatore: Today we're talking tariffs, a major policy issue at stake in the US presidential election. We'll dig into the domestic and international implications of these proposed policies.

It's Tuesday, October 1st at 10am in New York.

In a little over four weeks, Americans will be going to the polls. And as we've noted on this podcast, it's still a close race between the two presidential candidates. Former president Donald Trump's main pitch to voters has to do with the economy. And tariffs and tax cuts are central to many of his campaign speeches.

Arunima Sinha: You're right, Ariana. In fact, I would say that tariffs have been the key theme he keeps on coming back to. You've recently written a note about why we should take the Republicans proposed policies on tariffs seriously. What's your broad outlook in a Trump win scenario?

Ariana Salvatore: Well, first and foremost, I think it's important to note that the President has quite a bit of discretion when it comes to trade policy. That's why we recommend that investors should take seriously a number of these proposals. Many of the authorities are already in place and could be easily leveraged if Trump were to win in November and follow through on those campaign promises. He did it with China in 2018 to 2019, leveraging Section 301 Authority, and many of that could be done easily if he were to win again.

Arunima Sinha: And could you just walk us through some of the specifics of Trump's tariff proposals? What are the options at the President's disposal?

Ariana Salvatore: Sure. So, he's floated a number of tariff proposals -- whether it be 10 per cent tariffs across the board on all of our imports, 60 per cent specifically on China or targeted tariffs on certain goods coming from partners like Mexico, for example. Targeted tariffs are likely the easiest place to start, especially if we see an incrementalist approach like we saw during the first Trump term over the course of 2018 to 2019.

Arunima Sinha: And how quickly would these tariffs be implemented if Trump were to win?

Ariana Salvatore: The answer to that really depends on the type of authorities being leveraged here. There are a few different procedures associated with each of the tariffs that I mentioned just now. For example, if the president is using Section 301 authorities, that usually requires a period of investigation by the USTR -- or the US Trade Representative --before the formal recommendation for tariffs.

However, given that many of these authorities are already in place, to the extent that the former president wants to levy tariffs on China, for example, it can be done pretty seamlessly. Conversely, if you were to ask his cabinet to initiate a new tariff investigation, depending on the authority used, that could take anywhere from weeks to months. Section 232 investigations have a maximum timeline of 270 days.

There's also a chance that he uses something called IEEPA, the International Emergency Economic Powers Act, to justify quicker tariff imposition, though the legality of that authority hasn't been fully tested yet. Back in 2019, when Trump said he would use IEEPA to impose 5 per cent tariffs on all Mexican imports, he called off those plans before the tariffs actually came into effect.

Arunima Sinha: And could you give us a little more specific[s] about which countries would be impacted in this potential next round of tariffs -- and to what extent?

Ariana Salvatore: Yeah, in our analysis, which you'll get into in a moment, we focus on the potential for a 10 per cent across the board tariff that I mentioned, in conjunction with the 60 per cent tariff on Chinese goods. Obviously, when you map that to who our largest trading partners are, it's clear that Mexico and China would be impacted most directly, followed by Canada and the EU.

Specifically on the EU, we have those section 232 steel and aluminum tariffs coming up for review in early 2025, and the US-MCA or the agreement that replaced NAFTA is set for review later in 2026. So, we see plenty of trade catalysts on the horizon. We also see an underappreciated risk of tariffs on Mexico using precedent from Trump's first term, especially if immigration continues to be such a politically salient issue for voters.

Given all of this, it seems that tariffs will create a lot of friction in global trade. What's your outlook, Arunima?

Arunima Sinha: Well, Arianna, we do expect a hit to growth, and a near term rise in inflation in the US. In the EU, our economists also expect a negative impact on growth. And in other economies, there are several considerations. How would tariffs impact the ongoing supply chain diversification? The extent of foreign exchange moves? Are bilateral negotiations being pursued by the other countries? And so on.

Ariana Salvatore: So, a natural follow up question here is not only the impact to the countries that would be affected by US tariffs, but how they might respond. What do you see happening there?

Arunima Sinha: In the note, we talked with our China economists, and they expect that if the US were to impose 60 per cent tariffs on Chinese goods, Beijing may impose retaliatory tariffs and some non-tariff measures like it did back in 2018-19. But they don't expect meaningful sanctions or restrictions on US enterprises that are already well embedded in China's supply chain.

On the policy side, Beijing would likely resort less to Chinese currency depreciation but focus more on supply chain diversifications to mitigate the tariff shock this time round. Our economists think that the risk of more entrenched deflationary pressures from potential tariff disruptions may increase the urgency for Beijing to shift its policy framework towards economic rebalancing to consumption.

In Europe, our economists expect that targeted tariffs will be met with challenges at the WTO and retaliatory tariffs on American exports to Europe, following the pattern from 2018-19, along with bilateral trade negotiations. In Mexico, our economists think that there could be a response with tariffs on agricultural products, mainly corn and soybeans.

Ariana Salvatore: So, bringing it back to the US, what do you see the macro impact from tariffs being in terms of economic growth or inflation?

Arunima Sinha: We did a fairly extensive analysis where we both looked at the aggregate impacts on the US as well as sectoral impacts that we'll get into. We think that a pretty reasonable estimate of the effect of both a 60 per cent tariff on China and a 10 per cent blanket tariff on the rest of the world is an increase of 0.9 per cent in the headline PCE prices that takes into effect over 2025, and a decline of 1.4 percentage points in real GDP growth that plays out over a longer period going into 2026.

Ariana Salvatore: So, your team is expecting two more Fed cuts this year and four by the first half of 2025. Thinking about how tariffs might play into that dynamic, do you see them influencing Fed policy at all?

Arunima Sinha: Well, under the tariff scenario, we think that it's possible that the Fed decides to delay cuts first and then speed up the pace of easing. So, in theory, the effect of a tariff shock is really just a level shift in prices. And in other words, it's a transitory boost to inflation that should fade over time.

Because it's a temporary shock. The Fed can, in principle look through it as long as inflation expectations remain anchored. And this is what we saw in the FOMC minutes from the 2018 meetings. In a scenario of increased tariffs, we think that the uncertainty about the length of the inflationary push may slow down the pace of cuts in the first half of 2025. And then once GDP deceleration becomes more pronounced, the Fed might then cut faster in the second half of [20]25 to avoid that big, outsized deceleration and economic activity.

Ariana Salvatore: And what about second order effects on things like business investment or employment? We talked about agriculture as a potential target for retaliatory tariffs, but what other US sectors and industries would be most affected by these type of plans?

Arunima Sinha: That's something that we have leaned in on, and we do expect some important second round effects. So, if you have lower economic activity, that would lower employment, that lowers income, that lowers consumption further -- so that standard multiplier effect.

So overall, in that scenario, with the 60 per cent tariffs on China, 10 per cent on the rest of the world that are imposed fully and swiftly, we model that real consumption would decline by 3 per cent, business investment would fall by 3.1 per cent, and monthly job gains would fall by between 50- and 70, 000.

At the sectoral level, this combination of tariffs have potential to increase average tariffs to the 25 to 35 per cent range for almost 50 per cent of the NAICS industries in the United States when first put into place. And we expect the biggest impacts on computers and electronics, apparel, and the furniture sectors; but this does not take into account any potential exclusion lists that might be put into place.

Ariana Salvatore: Finally, what does all this boil down to in terms of a direct impact to the US consumer wallet?

Arunima Sinha: So, the impact of higher tariffs on consumer spending would depend on many factors, and one of the most important ones is the price elasticity of demand. So how willing would consumers be to take on those higher prices from tariffs, or do we see a pullback in real demand? What we think will happen is that higher prices could reduce real consumption by as much as 2. 5 per cent. The impact on goods consumption is much more meaningful because imported goods are directly affected by tariffs, and we would expect to see a drag on real goods consumption of 5 per cent. But then you have lower labor income and higher production costs and services prices that is also going to bring down services consumption by 1.3 per cent.

Ariana Salvatore: So, it's important to keep in mind here that US tariff policy would undoubtedly have far reaching consequences. That means it's something that we're going to continue to follow very closely. Arunima, thanks so much for taking the time to talk.

Arunima Sinha: Great speaking with you, Ariana. Thank you,

Ariana Salvatore: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.