US Macro: Upping the trade war ante – what does it mean for inflation? – President Trump has upped the stakes in his combative trade policy in recent days, by proposing to increase the planned tariff on $200bn in imports from China from 10% to 25% (this is in addition to the current 25% tariff on $34bn of imports, and imminently on a further $16bn – making for a total of $250bn potentially). We suspect the President has been emboldened by his success in extracting concessions from the European Union with the US’s recent threat of car tariffs, which has been put on ice for now (see here). It may also be a recognition that a 10% tariff would have been largely neutralised by the recent weakness in the CNY, which has now fallen by 8.3% against the USD from its April peak. Indeed, a 10% tariff would have essentially negligible macro implications, but a 25% tariff would almost certainly put upward pressure on inflation. Assuming full pass-through, and the offsetting effect of USD strength vs the CNY, we estimate it could push up headline CPI inflation by up to 20bp in 2019 (to 2.4%), and both core CPI and core PCE inflation by up to 30bp (to 2.4% and 2.3%). In reality, there is enormous uncertainty over the extent to which costs would be passed on to consumers. Where possible, businesses would probably prefer to absorb the hit to margins initially, especially if they do not believe tariffs are permanent and could be reversed.
Should businesses indeed fully pass on the tariff costs, would this be enough to alter the path of Fed policy? This will hinge on two crucial, but unpredictable factors: 1) whether business confidence declines on the back of trade policy uncertainty, and 2) whether inflation expectations begin to drift higher. All else equal, the former would lead to a more dovish Fed policy stance, while the latter would lead to a more hawkish policy stance. While a 25% tariff on $250bn of imports is significant, we suspect both business confidence and inflation expectations would weather it. But this is something we would need to monitor closely, and with this upping in the trade war ante, the range of macro and policy outcomes has increased further. (Bill Diviney)