The stock market and other financial markets are setting up for their fears of what may stem from Trump's tariffs -- recession and the costs of major shifts in the global economy. However, it will take time to determine how the fall-out from the tariffs plays out, as discussed below. So, the market sell-off may become excessive if the worst of the fears don't happen, and some recovery near term is possible. This week's release of the March CPI could help, as it risks being soft (consensus is 0.1% m/m Total and 0.3% Core, which can't be ruled out but risks being too high). To be sure, an end of the sell-off may require the stock market to overshoot and hit an important support level. Or, the market may find relief if there is movement by countries to negotiate with the US.
1. Tariffs as a Tax on the Consumer
Expectation of a recession stems from the role of tariffs as a tax on the consumer. Assuming full pass-through of the tariffs to prices and no change in spending composition, Trump's tariffs would cut consumers' purchasing power by $1Tn per year, including the tariffs on steel, aluminum and autos, according to news services. This represents about 3.5% of GDP, making it the largest tax hike relative to GDP since 1942 .
The drop in Real GDP would be less under some scenarios. /1/ If people reduce their saving rather than spend and pay the higher prices. /2/ If people shift the composition of their spending toward domestically-produced goods and away from imports. /3/ Other countries cut their exports or their prices to the US.
2. Prices of Domestically-Produced Goods
The drop in Real GDP could be worse if domestic producers lift their prices, taking advantage of weakened competition from imports. Price hikes by domestic producers would eliminate the ability of consumers to avoid paying the tariffs by shifting the composition of their spending. The hikes by themselves would cut consumer purchasing power (and boost the companies' profits), as well. So far, however, a couple of domestic auto companies have cut prices temporarily. One auto company is holding prices steady at this point.
3. Shift in Demand to Domestic Producers
A shift to domestically-produced goods, as apparently some auto companies have begun to do, not only could allow consumers to avoid paying the tariff, it would boost GDP. At the extreme, there would not be a recession but instead stronger economic growth. The problem then would be that the increased domestic production would have to displace other domestic production if the economy is operating near full capacity (as it is now). In particular, demand for labor could climb and exert upward pressure on wage inflation. Higher interest rates, weaker stocks and higher inflation are ways the markets would accomplish the "crowding out." When the economy is operating at full employment, the eventual outcome would be the same level of GDP as what would have been the case without the tariffs, but the composition of output would differ.
4. Retaliation
Some countries already have responded to the tariffs by imposing their own. Anger at the US reportedly has prompted Canadians to cancel travel to the US, which is a reduction in US services exports, and to impose tariffs on some US motor vehicles. China is about to impose tariffs on US goods. It also has retaliated by limiting sales of rare earth minerals. The next shoe to drop could be the European Union, although some European countries (eg Italy and Ireland) appear to be arguing against or for modest retaliation. Vietnam appears to be moving in that direction, as it has offered to drop all its tariffs on US goods. Note that dropping its tariffs may not be enough to placate Trump -- Vietnam controls its currency and may be holding it down relative to the dollar.
5. Price Inflation
There are several ways that tariffs could precipitate higher price inflation. /1/ A pass-through of the tariffs, /2/ matching price hikes by domestic producers, /3/ shortages created by other countries' retaliatory actions, and /4/ higher wage inflation resulting from increased demand for labor or from a push by labor to catch up to the higher prices.
These channels may take time to work through. So, inflation measures, like the CPI and PCE Deflator, could have high prints for a number of months, even if the pass-through is one-off as the Fed thinks is likely. A full pass-through of the tariffs would boost the PCE Deflator by 5%. Wage inflation will be important to watch. A speedup in wages would suggest that a "wage-price spiral" is a more likely consequence of the tariffs than the one-off idea.
6. Fed Policy
The Fed will eventually cut rates to fight recession, but may be slow to do so while inflation stays high. The Fed would manage both issues well by first letting the economy weaken and unemployment rise and then easing to end the recession. Creating labor market slack initially would allow the economy to resume growing without boosting inflation.
7. Fiscal Policy
Trump may be hoping that an extension of his earlier tax cuts will offset the drag from tariffs. However, the extension shouldn't be viewed in the way done by the Congressional Budget Office (CBO). The CBO measures it against a baseline where the tax cuts are allowed to expire. Doing so, CBO estimates the extension would cost $4.6 Tn over 10 years. This is the 10-year sum, not the annual amount. In terms of offsetting the tariffs, however, it is the sequential change that matters. And, a simple extension would add zero sequentially. So, it would not offset the drag from tariffs.