Tariff Strategies Don’t Cause Inflation, But Trade Wars Do

A regular series on the choices faced by international economic policymakers

After a raucous campaign and disorienting transition, the United States is about to see just what sort of trade policy President Donald Trump has in mind. But whether it will be transactional, transformative, or simply confusing remains to be seen. All three look likely over the next four years, and their combined effect seem sure to boost inflation and reduce growth.

Purists will argue that tariffs are merely a tool to pressure trading partners into better behavior and are little more than a one-off adjustment in relative prices. A Chinese-made electric vehicle with 100 percent tariffs will encourage more purchases of U.S.-built Teslas and Rivians. A tariff on French wine is a boon for Napa Valley. So far, so good.

The problem, however, is less with the economics of tariffs than the politics. No self-respecting leader, elected or not, can allow the U.S. president to punish its national exports without retaliating. That is why Canada, China, Europe, Mexico, and others have all issued clear statements that they are preparing their own tariff lists of U.S. targets.

As the world enters a new global trade order in which tariffs have become a central policy tool, every supply chain manager and consumer has to plan for the chance that purchases from abroad could suddenly face a stiff surcharge. And when Trump speaks of tariffs in the range of 60–100 percent, those adjustments can be significant.

Inflation remains a mysterious phenomenon that experts and quantitative models regularly get wrong. As the United States has recently experienced, price increases do not immediately start accelerating when governments print vast amounts of money or when unemployment hits historic lows. An economy operating at the neutral, not-too-hot, not-too-cold, inflation rate should easily adapt to a few tariffs on imports. This is especially true when imports represent just 14 percent of gross domestic product.

On the merits, there is a case that tariffs could provide leverage to force a trading partner to play fair, without subsidies or market access restrictions. The problem with that argument, however, is that the other government has to know what reforms it should undertake to avoid the tariffs. Even if Chinese leader Xi Jinping wanted to make changes, he would first need to know what specifically would head off confrontation.

There is also a reasonable argument for tariffs that protect a particularly important industry, which today seems to include solar panels and electric vehicle batteries. The temporary benefits to producers could, in some cases, justify the added costs to consumers. But policymakers need to be sure that this protection is time-limited to prevent targeted tariffs from turning into a permanent subsidy to an industry that will never compete globally.

A cash-strapped Trump administration could even argue that tariffs will bring in a few more nickels and dimes to help fill a yawning budget deficit. But they would have to be very desperate: tariffs represent less than 2 percent of total federal revenues and have not been a significant source of money for more than a century, dating back to when the coast guard was collecting money on behalf of the Treasury. Realistically, tariffs cannot be relied on to reduce dependence on imports and provide a fresh source of revenue at the same time.

If escalating rounds of tariffs and retaliation need not set off a fresh inflationary spiral alone, there is also no argument to be made that they are disinflationary. Indeed, the only way a trade war helps the Federal Reserve reach its mandated 2 percent inflation target is through a sharp recession, as they did in a very big way following the Smoot-Hawley Tariff Act of 1930.

But these days, when the latest consumer price inflation level seems stuck near 3 percent, it seems more likely that the risks of rising prices on imports will do more to hurt price stability than help. If the United States is really facing a new era of tariffs and counter-tariffs, it poses significant risks to the anchoring of inflation expectations.

Tariffs are not necessarily a problem, but trade wars are.

Christopher Smart, a former senior economic advisor in the Obama Administration, is managing partner of the Arbroath Group and writes “Leading Thoughts” on Substack.