The potential imposition of a 25% tariff on US imports from Mexico and Canada has triggered a round of frenetic economic modeling. Setting aside macro models’ inherent flaws (see ‘Behind The Curtain’), it is worth dissecting the challenge economists face when accounting for changes in trade policies.
A first step would consist in determining the elasticity of the demand and supply for the affected goods.
Demand elasticity reflects importers’ sensitivity to price increases. A key driver of that elasticity is the domestic substitutability of imports (consider the difference between tequila/alcohol and specified automotive parts). When alternatives are scarce and demand is inelastic, importers—both businesses and consumers—will be prepared to absorb higher costs, squeezing earnings.
Supply elasticity reflects exporters’ sensitivity to price reductions. Indeed, goods may need to be discounted to remain competitive once the import tariff is added. When exporters can re-route trade to alternative markets (smartphones or machinery vs. specified automotive parts), they will be less sensitive to losing volume in the US and able to protect their earnings.
An inelastic demand (low price sensitivity for importers) and an elastic supply (high price sensitivity for exporters) would lead to high US price increases, as experienced during the 2017-18 China trade war.
Unfortunately, more than half of US imports are intermediate goods. The impact of price increases for traded goods must be estimated for the entire value chain to which they contribute. Thus, tariffs can be expected to cause one-time price increases across the US economy – a transitory impact on inflation.
As economists seek to estimate the economic impact of tariffs, they must contend with another, highly volatile variable: foreign exchange rates. Indeed, a stronger dollar blunts the cost increase for importers (and mitigates inflation). But it also makes the US less competitive – a trend that may be compounded by anti-USA sentiment-fueled patriotic buying in affected nations and, possibly, beyond.
This leads to a broader question: how will changes in the macroeconomic environment—GDP headwinds due to rising consumer prices and a stronger USD (possibly cushioned by tariff revenue redistribution to consumers), supply chain disruptions with lasting impact on inflation (remember COVID), potential changes in employment and inflation expectations—affect Fed policy?
Regardless of the Fed’s policy stance, the temperamental 10-year Treasury yield, which impacts investments, equity valuations, and household wealth, may rise (or not).
Taking a longer-term perspective, and according to Michael Pettis in ‘How Tariffs Can Help America’ (2024), US tariffs can be designed to subsidize domestic production at the expense of consumption to rebalance the US economy.1 The resulting consumer-to-producer shift would, through a virtuous circle, lead to higher employment, higher wages, and lower inequality. This thesis is naturally debated.
If the economic impact of new tariffs is unpredictable, the real risk remains in the unpredictability of trade policy itself. Corporate decision-making calls for a measured approach: delaying reactions to the news cycle, avoiding impetuous moves, monitoring ‘real’ developments, and being prepared to take calculated risks to adapt to new dynamics once established (below some due diligence thoughts).
1 Since China has a reverse imbalance (too much production, not enough consumption), the imposition of tariffs on imports is not rebalancing the economy but worsens the imbalance, which limits China’s retaliatory options.
High-level self/investor due diligence list to assess tariffs-related cash flow impacts
Quantify the portion of revenues subject to tariffs under various scenarios
Assess the potential supply chain impact of tariffs on input costs (check SPLC on Bloomberg)
Assess the option and related costs to shift sourcing/production to exporting (destination) markets
Evaluate the ability to pass tariff costs to consumers while minimizing the impact on volume/market share
Review fixed-price agreements that may limit cost-passing flexibility
Consider reputational risks from price hikes or production shifts
Assess competitors’ reactions
Estimate additional compliance costs
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