Earlier this week, US President Elect Donald Trump threatened to apply tariffs to both Mexico and Canada if those countries didn’t take more action to curb illegal migration and drugs. The two affected dollars and the peso reacted as headlines focused on the implications of tariffs. While tariffs cause inflation seems to be a given in most of the coverage, is that really true do Tariffs raise inflation? If not, it means we could have an unexpected move in several major currencies in the future.
The first thing to get out of the way is that many analysts are looking at this issue as if the tariffs will actually be applied. That is something reasonable to account for as a possibility, but Trump’s statement was quite clear that it was a threat over immigration, not trade. Presumably, if Mexico and Canada take the actions on immigration and drugs that the future Trump Administration wants – a more likely scenario, given the history between the USMC partners – then the tariffs won’t come into effect. The market’s reaction might have been a bit premature.
The Expected Results
Going beyond just Mexico and Canada, Trump has threatened tariffs primarily against China, but also across the board to pretty much every country in the world. So, as currency traders, we really need to know if that will affect any of the currencies. For example, one of the currencies that is most vulnerable, at least to the authorities managing it, is the Euro.
Conventional thinking is that if a tariff is applied to goods, then the importers will add that additional cost onto the price. Those higher prices will filter through to consumers, raising inflation. That’s a quick analysis of the situation, largely based on what normally happens when a country raises taxes. This was seen in Japan in 2019 when it raised sales taxes by 2 percentage points back in 2019.
The Complicating Factor
Even among Trump’s entourage, there is acknowledgement of the inflationary impact of tariffs. His proposed Treasury Secretary Scott Bessent is a proponent of tariffs, and acknowledges that the cost will be passed on to consumers. But, he argues, it will be a one time thing. That is, once the tax is applied, importers will raise prices to compensate, and then prices will remain stable afterwards. This, also, tracks with what happened in Japan in 2019.
Normally, inflation is caused by demand exceeding supply, so prices will keep rising until there is a new equilibrium. This can last for months or years, depending on the root cause of the demand-supply imbalance and what monetary authorities do about it. So Bessent’s view also makes sense.
The Scale of the Matter
The US last year reported a record high amount of $3.83 trillion, or about 14% of the total value of the economy. A 10% tariff on all of those goods and services (assuming there are no exceptions or loopholes to be taken advantage of) translates into a 1.4% increase in prices, likely spread out over a period of a few months.
But, this is assuming the importer passes the cost on to the consumer. However, foreign products generally compete with domestic products on the basis of price – this is certainly the case for commodities. In that case, if the importer raises their price, they can lose their competitive advantage. Which gives them an incentive to take on the cost of the tariff, at least in part, to keep their product’s price point at an attractive level for consumers. After all, selling at a lower margin is preferable to not selling at all.
How Does it All Shake Out?
How much of this effect is in place varies from product to product. For example, disposable batteries made in China are attractive because they are cheap. But a Ferrari is attractive because of its brand. The Chinese battery manufacturer might opt to keep selling at the same price to keep consumers, while Ferrari or Louis Vuitton might rely on their luxury status to pass the cost on to the consumer. Of course there are intermediate products, such as clothing. Some people are willing to pay a premium for a brand; others will give up on a brand if it isn’t cheaper.
There are literally millions of items exported to the US each year, so it’s really difficult to assess a priori which importer will apply which strategy. What is clear is that tariffs can be inflationary, but the impact on CPI might be a bit overblown in popular media. If inflation isn’t as much as expected, then the Fed could ease more, and leave the dollar weaker than some traders might be pricing in.
But, in the end, what matters even more is what the market thinks will happen. If the market thinks that tariffs are inflationary, they will price in higher rates – until we get the actual inflation data. Then the markets will correct depending on how things actually turn out.
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