President Donald Trump has said that tariff is the most beautiful word in the English language. Well, as roses have thorns, it is now clear that significant negative economic impacts will likely be attached to his beautiful word.
For economists, one of the ugliest words is what the president’s policies threaten: Stagflation. We may be already headed in that direction.
Stagflation is a combination of stagnation and inflation. It was coined in 1965 by former British Chancellor of the Exchequer Iain Macleod. When speaking to Parliament about the economy, where prices were rising and growth was faltering, he remarked that “we now have the worst of both worlds … We have a sort of stagflation situation.”
Stock markets are falling sharply on the dual fears of recession and inflation. That is a warning sign the negative impacts of the trade war, inflation, and stagnation are taking hold.
Effects of the trade war have only just begun
If the president goes through with his tariff threats, price increases will spread throughout the economy. This will ultimately affect most consumer goods, business inputs, housing, and the services provided by the government, including medical care, road building, and going to Mars.
Given that wage gains are slowing, household purchasing power — and therefore confidence and spending — are likely to deteriorate.
In other words, stagflation.
A crisis for the Federal Reserve
When fiscal policy creates economic problems, it’s the Fed’s job to clean up the mess. The Fed has a dual mandate to maximize employment with stable prices. With inflation threatening to accelerate and growth moderating, the Fed is caught in a bind.
When the economy softens, the Fed lowers rates and makes capital more available. Households can more easily borrow for big-ticket items such as homes or vehicles, while businesses can better afford to invest in machinery and equipment. That is supposed to increase growth.
But when inflation is high and/or rising, the Fed should be raising rates to lessen demand and take the pressure off prices.
The Fed cannot lower rates to improve growth and raise rates to slow demand at the same time.
Also, the Fed has little control over tariff-driven inflation. Political actions such as tariffs, not economic factors such as excess demand, are threatening supply chains and imposing increases in supply costs that are causing the inflationary fears. The ability of the Fed to act against this type of inflation is limited at best.
What will the Fed wind up doing? Unclear. The Fed fears the tariff-induced inflation will spread to the broader economy. Consequently, it is likely to maintain the current relatively high interest rates longer than they would if the tariff-induced inflation didn’t exist. It might also reduce rates more slowly, unless there is a sustained recession.
Where does tariff policy go from here?
The president has a few options:
He could declare victory and stop the tariff war. Possible but not likely.
He could “permanently” impose the tariffs and allow the longer-term impacts to play out. Possible.
Over time, businesses and households will adjust. U.S. consumers, businesses and investors will ultimately bear the full burden of the tariffs, and the higher prices will become embedded in the cost of living. How long that will take is anyone’s guess, but the longer the process, the greater the impacts.
Trump also could continue to ramp up pressure in the hopes of winning the war. Likely.
Tariff strategy is unlikely to lead to much more U.S. production
The president’s endgame is to create a more balanced playing field for American businesses, thereby bringing production back to the U.S. That makes sense.
It is impossible to argue that the global trade playing field is fair right now. Something needs to be done. In the book I cowrote eleven years ago, Big Picture Economics, I made that specific argument.
But firms adjust production locations largely on the basis of production and transportation costs. For example, after the U.S./China tariff war during the first Trump administration, even Chinese companies moved out of China.
Where did they go? To the “New China” — Vietnam, which is now booming. They didn’t come to the U.S.
Is there a better way?
With the entire world open for firms to locate, addressing the differences in production costs necessitates placing tariffs on products in a manner that raises import prices to near or above U.S. production costs. That entails a complex structure that sets individual tariffs on each product for each individual nation.
Good luck implementing that, especially since it ensures the prices of everything we get from the rest of world would rise, in many cases significantly.
Another alternative is to negotiate reductions in barriers to trade everywhere, an approach that has benefited firms and consumers through lower prices but has battered industries that cannot compete. Unfortunately, as we know, other nations cheat.
Or finally, we can institute an “industrial policy”/protectionism strategy that picks winners and losers for tariff protection. That is a favorite of most politicians, including Trump, but something conservatives call socialism.
The president’s approach makes little sense
Trump has decided to go to war against our three largest trading partners based on size, not necessarily on the barriers to trade imposed by each country. The tariff retaliations will continue.
He has chosen a path that doesn’t ensure significant long-term increases in domestic manufacturing. Firms will produce in countries where labor costs remain low, and no American president can force another country to raise its wages.
If Trump continues on that path, it will lead to rising inflation, keep interest rates elevated, and slow the economy, possibly enough to drive it into a recession.
As for waiting for all the positive impacts to appear, I can only quote the famous economist John Maynard Keynes: “ … the long run is a misleading guide to current affairs. In the long run, we are all dead.”