US tariffs point to a sharp US contraction & global downturn

The largest US tariffs since the late 1800s combined with extreme policy uncertainty point to a sharp contraction in US output and raise the risk of a synchronised global downturn, placing downward pressure on interest rates, including in Australia.

President Trump has announced the latest round of tariffs, focusing on reciprocal tariffs, which raise US tariffs to match tariffs charged by other countries, but also increase them to match value-added tax rates and perceived non-tariff trade barriers. Expected announcements on other specific goods – such as pharmaceuticals and semiconductors are not announced – were not made.

• Reciprocal tariffs based on matching tariffs charged on US goods imported by other countries mainly hurt emerging markets. Emerging markets rely more on tariffs out of necessity because they have limited options to tax income (as was the case in Trump’s much-cited example of the US in the late 1800s). Tariffs charged by advanced economies – including pre-Trump tariffs – are uniformly very low, as negotiated under world trade agreements.
  
  
• Reciprocal tariffs based on value-added taxes have no economic grounding because both domestic producers and US exporters face the same VAT rate. These tariffs apply to advanced economies, where the standard administrative rate is about 20%. The US is unique in not having a national VAT, with different state government charging VATs instead.
  
  
• Reciprocal tariffs based on non-tariff trade barriers are hard to gauge and the administration seems to have taken an arbitrary approach instead.

President Trump has imposed a 10% universal tariff as a baseline and then a set of higher reciprocal tariffs on a large range of trading partners, ranging between 15% and 49%, where the brunt of the policy is borne by China and the rest of Asia.

The higher reciprocal tariff rates were termed “discounted reciprocal tariff rates” because they were lower than the administration’s estimates of “tariffs charged to the US, including currency manipulation and trade barriers”.

The administration’s estimates of “tariffs charged to the US, including currency manipulation and trade barriers” seem implausible. 

For example, the quoted rate of 39% for the European Union is much higher than the sum of the union’s c1¼% effective tariff rate and the c20% average VAT rate. At the other extreme, the 10% quoted rate for the UK is below the sum of the UK’s 3% effective tariff rate and the 20% VAT rate.

Instead, it was later confirmed that the estimates of “tariffs charged to the US, including currency manipulation and trade barriers” were based on the value of a country's trade deficit with the US divided by the value of its exports of goods to the US, defaulting to a 10% tariff in the case of a small ratio or a country where the US runs a trade surplus.  

Prior to Trump’s second term, the effective US tariff rate was about 3%. Recently announced tariffs on China, Canada, Mexico, automobiles, steel and aluminium raised that rate by an estimated 11pp to about 14% and today’s tariffs increase that by an additional 18pp to about 32%.

In practice, the effective tariff rate will not reach that level because the demand for imports should slump, such that the revenue raised by the tariffs will be much lower than seemingly believed by the president’s advisors. The administration might also end up making some exemptions over coming days.

However, at face value the 32% effective tariff rate exceeds the 24% peak of disastrous Smoot-Hawley tariffs introduced in the Great Depression of the 1930s and would be the highest rate since the late 1800s.

The tariffs, plus extreme policy uncertainty, are likely to see a sharp contraction in activity and there is now a much higher risk of a synchronised global downturn, even if other countries do not retaliate to the same degree and attempt to stimulate their economy. 

Depending on whether inflation expectations become unmoored, this points to further downward pressure on policy interest rates across the advanced economies, including Australia.