As Trump Threatens China Again, Here’s What Happens To Inflation In A Worst-Case Tariff Scenario

Following a tumultuous week for global markets that found the Trump administration more than doubling the tariff rate on $200 billion in Chinese goods and threatening to slap duties on the remainder of Chinese imports within a month if Beijing doesn’t roll over, it would have been advisable for the US president to take a break from chastising the Chinese.

After all, Trump essentially forced Vice Premier Liu He to fly halfway around the world and sit across the table from Bob Lighthizer even as the US moved ahead with more tariffs and even though the chances of striking a deal by the end of the week were effectively zero.

In other words, Trump appeared to delight in embarrassing Liu, something he (Trump) made clear while speaking during an event ostensibly convened to talk about “medical billing”.

“It was their idea to come back”, Trump told a reporter who asked about the state of the negotiations, making it seem as though China was desperate.

Fast forward to Friday and Trump was busy stumbling his way through a nonsensical series of tweets designed to explain away this week’s trade escalation and otherwise spin the drama as unequivocally positive for the US no matter how things turn out.

US stocks managed to close on an upbeat (read: green) note Friday, but it was still the worst week since Christmas. After the bell sounded on Wall Street, the USTR said details on prospective tariffs targeting another $300 billion in Chinese goods are coming on Monday.

Given how high tensions are running, everyone could have done without the following egregious “covfefe” which showed up on Trump’s Twitter Saturday evening:

I think that China felt they were being beaten so badly in the recent negotiation that they may as well wait around for the next election, 2020, to see if they could get lucky & have a Democrat win – in which case they would continue to rip-off the USA for $500 Billion a year. The only problem is that they know I am going to win (best economy & employment numbers in U.S. history, & much more), and the deal will become far worse for them if it has to be negotiated in my second term. Would be wise for them to act now, but love collecting BIG TARIFFS!

So, there’s Trump, lampooning the Chinese by couching the negotiations in terms of one side being “badly beaten”, on the way to threatening Beijing by suggesting that if this already protracted dispute somehow drags into 2021, he’s going to be even more incorrigible and obstinate, assuming that’s possible.

Of course, that would entail talks stalling until after the US election. By that time, the effects of the trade war would almost surely have waylaid the global economy, especially if you assume that in that hypothetical scenario, Trump will have been taxing the entirety of Chinese imports for some 18 months. If Q4 was any indication, global PMIs would plunge if Trump moved ahead with tariffs on all Chinese goods and proceeded to, for instance, hit European cars with levies in light of the Section 232 decision.

Meanwhile, stateside, it turns out that the effect of the tariffs on consumer prices over the last 18 months was, to quote Goldman, “larger than… previously estimated.”

Why’s that? Well, because “the costs of US tariffs have fallen entirely on US businesses and households, with no clear reduction in the prices charged by Chinese exporters” and also because “the effects of the tariffs have spilled over noticeably to the prices charged by US producers competing with tariff-affected goods.” So, exporters are not eating any of the costs and other folks are opportunistically raising prices – imagine that.

(Goldman)

The bank’s analysis is lengthy and characteristically trenchant, but for our purposes here, just note the following worst-case scenario which quantifies the effect on PCE assuming tariffs are placed on the remainder of Chinese imports and auto tariffs are implemented as well:

Imposing 25% tariffs on roughly $300bn of remaining Chinese imports would have a peak effect of 0.5pp on core PCE, while auto tariffs would have a roughly 0.3pp peak effect. These considerably larger effects reflect the much larger share of consumer goods that would be affected. If all proposed tariffs were implemented within a year, the total impact on core PCE would peak at around 0.9pp.

As far as the implications for the Fed are concerned, it’s hard to imagine that the US economy wouldn’t ultimately succumb in the event Trump actually did go all-in on everyone, where that means taxing the entirety of Chinese imports and moving ahead with auto tariffs. So, it’s possible the drag on growth would prompt the Fed to cut rates despite the upside risk to inflation. Indeed, higher prices would likely dent growth, given that more costly consumer goods would eat away at real incomes.

That said, if the US economy somehow managed to hold up, the estimated 0.9pp peak effect on PCE inflation would almost surely raise the odds of a hawkish policy response. That could serve as a further drag on growth (by tightening financial conditions) and assuming the Fed is unsuccessful at arresting inflation quickly, you may well get the worst possible outcome – stagflation.

Whatever the case, Trump is on the verge of making a truly historic error, which will be completely inexcusable in hindsight given that it’s predicated on a laughably misguided interpretation of trade deficits and a childlike conception of what it means to “win” in global commerce.