Trump starts a global trade war

The US government is imposing substantial tariffs on imports of goods from its longstanding ally Canada, as well as Mexico and China, with President Trump adding that he would “absolutely” impose a “very substantial” tariff on imports from the European Union at a later date.

Barring last-minute changes, the tariffs take effect Tuesday. Canada will be hit with split tariffs, with 10% on oil and gas and 25% on all other goods. Mexico is subject to a 25% tariff and the additional tariff on Chinese goods is 10%.

President Trump warned that the US could raise tariff rates further if any country retaliates, where Canada has announced a 25% tariff that applies to an increasing coverage of imported US goods over time. Mexico has signalled it will impose tariffs, while China will lodge a largely symbolic case against the US with the World Trade Organisation as it simultaneously takes tariff and non-tariff countermeasures (historically China has gone about one-for-one with changes in US tariff rates).

The White House said the tariffs were mainly in response to the flow of illegal drugs, specifically fentanyl. However, this argument does not tally with the varying tariffs applying to different countries, in that US government research notes that the bulk of fentanyl comes from Mexico, with China and India the main suppliers of the chemicals needed to manufacture the drug. Fentanyl sourced from Canada is negligible.

Another discrepancy concerns how the 10% tariff on China is only a fraction of Trump’s election promise of a 60% additional rate. This could reflect the influence of Musk, where Tesla has a large manufacturing plant in China, with China and the US evenly accounting for the vast bulk of Tesla sales.

Canada, Mexico and China account for 42% of US imports of goods, such that the Trump tariffs should increase the effective US tariff rate from 2½% to 10%, which would be the highest level since World War 2.

Adding in the European Union raises the import share to 61%, such that the effective tariff rate would reach 15% - which would be the highest rate since the Great Depression – on the arbitrary assumption of a "very substantial" 25% tariff on the region.

Goods account for 31% of US consumer spending, such that the tariffs on Canada, Mexico, and China would boost headline PCE inflation by about 1¼pp, building to about 2pp if a similarly punitive tariff is imposed on the European Union.

There are also likely to be significant disruptions to supply chains in key industries such as the auto sector, where some inputs into production cross the US border several times.

Importantly, these preliminary estimates of the potential impact on inflation should be treated as upper bounds because the effect on consumer prices will likely be diluted by some companies absorbing part of the increase in tariffs along the production chain, particularly when the US demand for imported goods should contract sharply, along with movements in exchange rates and possible substantial changes to the scope of the tariffs at a later date.

On the latter point, the tariffs could be subject to legal challenges, while companies will seek waivers. President Trump could also water down the tariffs, or even scrap them, depending on the reaction of the public and the stock market.

Nonetheless, the clear risk for the Federal Reserve is that a sustained increase in tariffs raises expected inflation, which would boost ongoing inflation. Early survey data already show that consumers who view tariffs negatively have materially higher short-term inflation expectations and slightly higher long-term expectations.

Unless the US government backs off at the last moment, the American tariffs should see at least a partial unwinding of globalisation, where globalisation has broadly peaked over recent years.  This points to higher average inflation at the margin, as globalisation has helped central banks in restraining world price pressures.