Economic Outlook Amid Tariff Changes and Fed Policy

After the federal court’s ruling against Trump’s reciprocal tariffs, and an appeals court’s temporary stay of that ruling, our analysts Michael Zezas and Michael Gapen discuss how the administration could retain the tariffs and what this means for the U.S. economy.

Read more insights from Morgan Stanley.

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Michael Zezas: Welcome to the Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income Research and Public Policy Strategy.

Michael Gapen: And I'm Michael Gapen, Chief U.S. Economist.

Today, the latest on President Trump's tariffs.

It's Thursday, May 29th at 5pm  in New York.

So, Mike, on Wednesday night, the U.S. Court of International Trade struck down President Trump's reciprocal tariffs. This ruling certainly seems like a fresh roadblock for the administration.

Michael Zezas: Yeah, that's right. But a quick word of caution. That doesn't mean we're supposed to conclude that the recent tariff hikes are a thing of the past. I think investors need to be aware that there's many plausible paths to keeping these tariffs exactly where they are right now.

Michael Zezas: First, while the administration is appealing this decision, the tariffs can stay in place. But even if courts ultimately rule against the Trump administration, there are other types of legal authorities that they can bring to bear to make sure that the tariff levels that are currently applied endure. So, what the court said the administration had done improperly was levy tariffs under the International Emergency Economic Powers Act (IEEPA).

And there's been active debate all along amongst legal scholars about if this was the right law to justify those tariff levies. And so, there's always the possibility of court challenges. But what the administration could do, if the courts continue to uphold the lower court's ruling, is basically leverage other legal authorities to continue these tariffs.

They could use Section 122 as a temporary authority to levy the 10 percent tariffs that were part of this kind of global tariff, following the reciprocal trade announcement. They also could use the existing Section 301 authority that was used to create tariffs on China in 2018 and 2019, and extend that across of all China imports; and therefore, fill in the gap that would be lost by not being able to use the International Emergency Economic Powers Act to tariff some of China's imports.

So bottom line, there's lots of different legal paths to keep tariffs where they are across the set of goods that they're already applied to.

Michael Gapen: So, I think that makes a lot of sense. And with all that said, where do you think we stand right now with tariffs?

Michael Zezas: So, if the court ruling were to stand then the 10 percent tariffs on all imports that the U.S. is currently levying, that would have to go away. The 30 percent tariffs on roughly half of China imports, that would've to go away. And the 25 percent tariffs on Canada and Mexico around fentanyl, that would have to go away as well.

What you'd be left with effectively is anything levied under section 232 or 301. So that's basically steel, aluminum, automobile tariffs. And tariffs on the roughly half of China imports that were started in 2018 and 2019. But as we said earlier, there's lots of different ways that the authority can be brought to bear to make sure that that 10 percent import tariff globally is continued as well as the incremental tariffs on China.

But Michael, turning to you on the U.S. economy, what’s your reaction to the court's ruling? It seems like we're just going to have a continuation of existing tariff policy, but is there something else that investors need to consider here?

Michael Gapen: Well, I'm not a trade lawyer. I'm not entirely surprised by the ruling. It did seem to exceed what I'll call the general parameters of the law, and it wasn't what we – as a research group and a research team – were thinking was the most likely path for tariffs coming into the year, as you mentioned. And as we, as a group wrote, we thought that they would rely mainly on section 301 and 232 authority, which would mean tariffs would ramp up much more slowly. And that's what we had put into our original outlook coming into the year.

We didn't have the effective tariff rate reaching 8 to 9 percent until around the middle of 2026. So, it reflected the fact that it would take effort and time for the administration to put its plans on tariffs in into place. So, I think this decision kind of shifts our views back in that direction. And by that I mean, we originally thought most of 2025 would be about getting the tariff structure in place. And therefore, the effects of tariffs would be hitting the economy mainly in 2026.

We obviously revise things where tariffs would weigh on activity in 2025 and postpone Fed cuts into 2026. So, I think what it does for the moment is maybe tilts risks back in the other direction. But as you say, it's just a matter of time that there appears to be enough legal authority here for the administration to implement their desires on trade policy and tariff policy. So, I'm not sure this changes a lot in terms of where we think the economy's going. So, I'm not entirely surprised by the decision, but I'm not sure that the decision means a lot for how we think about the U.S. economy.

Michael Zezas: Got it. So, the upshot there is – really no change from your perspective on the outlook for growth, for inflation or for Fed policy. Is that fair?

Michael Gapen: That's right. So, it's still a slow growth, sticky inflation, patient Fed. It's just we're kind of moving around when that materializes. We pulled it into 2025 given the abrupt increase in in tariffs and the use of the IEEPA authority. And now it probably would come later if the lower court ruling stands.

Michael Zezas: Right. So, sticking with the Fed. Several Fed speakers took to the airwaves last week, and it sounds like the Fed is still waiting for some of these public policy changes to have an effect on the real economy before they react. Is that a fair way to characterize it? And what are you watching at this point in terms of what determines your expectations for the Fed's policy path from here?

Michael Gapen: Yeah, that's right. And I think, given that the appeals court has allowed the tariffs to stay in place as they review the lower court, the trade court's ruling, I think the Fed right now would say: Okay, status quo, nothing has changed.

So, what does that mean? And what the Fed speakers said last week, and it also appeared in the minutes, is that the Fed expects that tariffs will do two things with respect to the Fed's mandate. It'll push inflation higher and puts risks around unemployment higher, right? So, the Fed is offsides, or likely to be offsides on both sides of its mandate.

So, what Fed speakers have been saying is, well, when this happens, we will react to whichever side of the mandate we're furthest from our target. And their forecasts seem to say and are pretty consistent with ours, that the Fed expects inflation to rise first, but the labor market to soften later. So, what that means for our expectations for the Fed's policy path is they're likely to be on hold as they evaluate that inflation shock.

And we'll keep the policy rate where it is to ensure that inflation expectations are stable. And then as the economy moderates and the labor market softens, then they can turn to cuts. But we don't think that happens until 2026. So, I don't think the ruling yesterday and the appeal process initiated today changes that.

For now, the tariffs are still in place. The Fed's message is it's going to take us at least until probably September, if not later, to figure out which way we should move. Moving later and right is preferable for them than moving earlier and wrong.

Michael Zezas: Got it. So bottom line, from our perspective, this court case was a big deal. However, because the administration has a lot of options to keep tariffs going in the direction that they want, not too much has really changed with our expectations for the outlook for either the tariff path and it's not going to fix to the economy.

Michael Gapen: That’s right. That's, I think what we know today. And we'll have to see how things evolve.

Michael Zezas: Yep. They seem to be evolving every day. Mike, thanks for speaking with me.

Michael Gapen: Thank you, Mike. It's been a pleasure. And thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.