Since it seems like tariffs are here to stay, deal or no deal, I am finally sitting down to share my thoughts on them—and their potential impact on the economy and your portfolios. The conventional wisdom is that tariffs increase prices, which will show up as inflation. Many economists agree with this, but I believe this analysis is too simplistic. They are ignoring second- and third-order effects. That doesn’t mean tariffs are good! It’s just that I think they are more likely to have the opposite—and more concerning effect—namely, deflation. This tariff and trade war shock may be what finally tips us into this long-expected economic slowdown.
Will Tariffs Bring Back Inflation?
- First off, yes, prices on specific impacted goods may initially rise and, unlike other types of taxes, would show up in headline inflation numbers. This is indeed showing up in the data, but it should be a one-time deal. The inflationary effects should roll off quickly unless we keep raising tariff rates over and over again in future years. Barring this, I would not expect even large tariffs to increase inflation on a sustained multiyear basis.
- But just because prices rise on some goods does not necessarily mean overall prices will rise. Think about this: If we suddenly have to pay more for one basket of goods, we will have less money to pay for everything else (domestic goods, services, etc.)—unless we suddenly receive a big bag of extra money out of nowhere. So unless we go more into debt or receive a stimulus from the money fairy, demand should fall for non-impacted goods and services, whose prices should fall, all else equal.
- Furthermore, all this assumes that importers are able to pass off some or any of these tariff costs onto us, their end consumers. If in the end they can’t, prices may not rise after all. Analyses I’ve seen so far indicate companies are so far “eating” a big portion of the tariff taxes. But to maintain their margins, they may have to lay off workers or lower investment rates, both of which would be more in their control and deeply deflationary.
- Also, how will we, as consumers, react to these higher prices on goods subject to tariffs? A lot of the products we’re talking about here are discretionary items (wants not needs). We may balk or defer purchases of such goods. A fall in demand may offset any momentary increase in asking prices.
- Finally, the ever-changing, on-again-off-again trade war affair is sure to have wreaked havoc on business decision-making. If you were a CEO right now, would you feel confident building a factory or expanding operations, even in the US? You don’t even know whether the rules of the game will last the weekend let alone the next few years. This risks a freezing up of business spending, which we are already seeing in the data with CEO confidence surveys. CEO confidence jumped to 60% in the wake of President Trump’s electoral victory, but it has cratered to around 40% (a recessionary level) since the tariff saga began.
What Does History Say About Tariffs?
Just as I’ve studied past market and economic history to hopefully find analogues to understand today, I looked back through history at previous tariff episodes. Were they inflationary? No, neither the McKinley Tariffs of the 1890s nor the famous Smoot-Hawley Tariff Act of 1930 led to inflation. On the contrary. They were both deflationary.
The McKinley Tariffs (1890s)
Given President Trump’s stated admiration for Turn-of-the-Century president William McKinley, and their shared belief in the use of tariffs, I recently read Robert Merry’s biography of McKinley, The Architect of the American Century. While our economic and monetary system was vastly different then and many other factors were involved so making parallels is fraught, McKinley’s tariffs were followed by two deflationary panics. In fact, by McKinley’s second presidential term, he was beginning to change his tune on tariffs, but then he was shockingly assassinated.
The Smoot-Hawley Tariff Act of 1930
And the Smoot-Hawley Tariff Act came in 1930 just as it looked like we were starting to recover from the 1929 stock market crash. While unemployment jumped to 9% in the immediate aftermath, it had recovered a lot and was down to 6% within a year. It looked like we were quickly on the road to recovery, as had happened with every other previous panic. It was at this time that Congress and President Hoover thought it would be a great idea to resurrect a high-tariff regime to supposedly protect domestic workers. Within five months of its passing, unemployment shot into the double-digits and never dropped below 10% for the rest of the decade! Many economists believe these tariffs, along with many other policy blunders, lengthened the worst economic misery we’ve experienced as a country outside of wartime.
What Comes Next?
So far, we probably haven’t really seen the true effects of the new world order of tariffs. To date, inflation effects have been muted and the economy hasn’t turned south … yet. But I think the recent jobs report shocked a lot of investors. It turns out there has been very little job creation this year. I wouldn’t even look at jobs reports if I didn’t see it reported on in the news so much. The sampling error on this data is just so large. What’s more, job creation is a lagging indicator. I prefer leading indicators. But this could be an early sign that companies are ceasing hiring in preparation to defend margins at risk due to tariffs.
All I can say is the truth about tariffs is probably somewhere in between “Inflationary Armageddon” (how the markets were acting in April) and “a New Gilded Age” (how the markets are acting now). As I watch the economic indicators continue to weaken, my fear is that the end of freer global trade will be the straw that breaks the camel’s back in terms of pushing us into recession. We will see.
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