The Tariff Tug-of-War: Balancing Economic Growth and Trade Relations

The first trade skirmish of the second Trump administration has reverberated through global markets, highlighting the ongoing uncertainty in international trade relations. The administration has postponed the imposition of 25% tariffs on imports from Canada and Mexico until 1 March, while the 10% increase on Chinese goods has taken effect, signaling a more aggressive stance toward China that is likely to persist.

If fully implemented, we estimate the tariffs on Canada, Mexico, and China could raise U.S. inflation by 0.8 percentage points and reduce growth by 1.2 points in the first year. In contrast, if only Chinese tariffs are implemented, the economic effects on the U.S. would likely be much more muted: Inflation could rise by roughly 0.2 percentage points, with a similarly sized impact on growth. The direct drag on growth from tariffs on Canada and Mexico is likely to be higher.

These risks complicate the Federal Reserve's monetary policy decisions as it strives for price stability while maximizing employment. A near-term rise in inflation would tend to delay further interest rate cuts, while potential economic slowdowns would suggest faster cuts and possibly a lower destination for the policy rate. Overall, we think the combination of elevated post-pandemic inflation and the strength of the U.S. economy will likely keep the Fed on hold for now.

Tariff strategy

We believe the Trump administration is determined to use tariffs not only to try to alter global trade and raise government revenues, but also to pressure countries on broader U.S. demands, including an accelerated review of the U.S.–Mexico–Canada Agreement (USMCA) and NATO defense spending requirements.

However, we believe the 40-year-old North American free trade bloc ultimately will survive, as the focus of tariff and trade policy will likely remain on China and other non-USMCA countries that run serial trade surpluses with the U.S. We believe these countries – including Germany and other European states, as well as Japan and Vietnam – should prepare for more U.S. policy volatility.

We expect to gain further insight into the details of future trade actions on 1 April, the deadline for several deliverables detailed in Trump’s executive order on trade.

Economic impact

Tariffs on Canada and Mexico would have a far larger economic impact than similar sized tariff hikes on China, due to the greater supply chain integration across North America and the larger scale and scope of the volume of trade affected.

If fully implemented, the new tariff rates will lift the effective average tariff rates on China, Mexico, and Canada to approximately 20%–25% total, increasing the average effective tariff rate on all U.S. imports by roughly 8 percentage points. This is a much greater increase compared to the roughly 1 percentage point increase in the average effective tariff rate during Trump’s first administration.

Furthermore, nearly 20% of the value of manufacturing products imported by the U.S. from its USMCA neighbors is generated domestically, compared with roughly 2% for Chinese products, according to OECD data. As a result, tariffs on Canada and Mexico would have more direct costs on U.S. manufacturers along the supply chains.

The economic impact will also depend on how these countries retaliate – in-kind retaliation would further reduce U.S. exports. Additionally, the extent of support from other governments will play a role – while the Canadian government would likely respond with sales tax holidays and manufacturing subsidies, Mexico has less fiscal space to support its economy. The reactions of financial markets and currencies are also crucial. A stronger U.S. dollar could potentially offset some near-term inflationary effects but could also hit the U.S. export sector.

The extent to which tariff revenues are “recycled” back into the U.S. economy is another key uncertainty. Higher revenues, if not offset by larger personal or corporate tax cuts, would tend to reduce U.S. government deficits, all else being equal, but this would likely result in a larger drag on activity in the near term. In general, we see less scope for government revenue recycling this time versus the first Trump administration, when higher tariffs were paired with tax reductions from the Tax Cuts and Jobs Act (TCJA).

The new tariffs have potentially offsetting implications for Federal Reserve policy. A near-term rise in inflation would tend to delay further interest rate cuts, while the potential drag on economic activity and labor markets would suggest faster cuts and possibly a lower destination for the policy rate.

The implications for other central banks may be more straightforward. While some retaliation that raises price levels in the affected economies is likely, the drag on economic activity from the rise in global trade uncertainty and the more direct impact from reduced trade in surplus economies are likely to be a bigger concern for central bankers. In the event of higher tariffs, we expect the Bank of Canada to focus on supporting growth with faster cuts. The Bank of Mexico (Banxico) is also likely to have a bias to cut more quickly, although the speed and magnitude of currency adjustments will be an important constraint.

Investment implications

As the U.S. continues to grapple with its trade relationships, the broader economic landscape remains uncertain. For more details, please see our recent Cyclical Outlook, “Uncertainty Is Certain.”

However, this uncertainty and market volatility could create opportunities for active managers. Fears of a tariff war boosted short-dated Treasury yields, while those on longer-maturity bonds fell. We believe tail risks for the U.S. economy, both positive and negative, may create a target-rich environment for investors, though caution and humility remain essential.

Overall, we believe bonds present an appealing opportunity in the near and long term, especially given their elevated starting yields. Additionally, bond markets outside the U.S. may benefit further; in the event of U.S. trade disruption, many central banks are poised to accelerate their rate-cutting cycles, bolstering the case for a global bond portfolio. When uncertainty rattles markets, bonds can provide valuable diversification properties in portfolios.