Payden & Rygel: For whom the tariff tolls
Consumers and businesses will pay the tariff toll, reducing economic growth and making America—and the world—poorer. Therefore, we think the growth drag will dwarf the inflationary impact of tariffs.
Over the weekend, the U.S. announced a new round of tariffs on Canada, Mexico, and China.1
Federal Reserve Chair Powell said last week that policymakers must wait for more details before determining the economic impact of new tariffs.
As stewards of capital, investors have no such luxury—or at least no such patience.
The 10-year yield has risen 100 bps since the fall of 2024. At least some of that move was driven by inflation concerns, with inflation breakevens (market-implied inflation expectations) back up to their levels in the spring of 2024.
In turn, far fewer rate cuts are priced in over the next 12 months, likely due to the market's assessment that inflation will remain problematic, which would require a restrictive fed funds rate for a longer time.
But is the market’s early assessment correct?
Powell is correct that the unknowns are vast. Countries will retaliate, consumers and businesses could shift buying preferences, imports could be substituted for other inputs, export nations could re-route their goods via other countries, chaos could ensue as companies scramble to find alternative inputs, Trump could change his mind, and so on.
So, a lot could change, but here’s a summary of our thinking as of the afternoon of 2 February 2025:
Tariffs are a tax—and potentially one of the most significant tax increases on U.S. households and businesses in the post-war era. Most empirical research shows that domestic consumers and firms bear the incidence of tariffs. As such, a tariff can be viewed in the same light as a sales tax increase (Californians will be all too familiar) or a VAT increase (for our European or Japanese readers) in terms of its burden on households.
Model estimates vary, but conservative estimates show that a 10% tariff would act like an annual consumption tax increase of about $1,500 per household year.2 Other estimates of the tax toll range from $1,900 to $7,600 per household per year.3 If the high-end of such estimates play out, the tariff burden on household income could equate to the largest tax increase in post-war history. To put tariffs in perspective, estimates suggest that Trump 1.0’s tax cuts only reduced the tax burden per household by $1,570.4
Tariffs will increase the price levels of imported goods but not necessarily the inflation rate. The impact on the overall inflation rate is more difficult to gauge. If incomes do not keep pace with price increases, consumers will economize, spending less elsewhere. In turn, the net effect on the general level of prices will be uncertain. In the Japanese VAT situation mentioned above, prices spiked initially, but inflation faded within a year.
Further complicating the inflation story, goods impacted by tariffs, including intermediate goods that become domestically produced, comprise about ~25% of consumer spending on goods, or only 10% of the total PCE basket, with services (haircuts, rents, insurance, etc.) making up the rest.
We aren’t surprised investors are concerned about inflation; during the Covid-19 supply chain crisis, core goods accounted for 35% of the core PCE inflation in January 2022. However, the primary drivers of inflation in the U.S. are housing and non-housing services, less impacted by tariff price shocks than goods prices.
U.S. economic growth will slow. Ultimately, we think the negative aspects of growth tariffs will dwarf the market’s current inflation concerns. First, consumer health was a key pillar of our relatively upbeat view on the U.S. economy in recent years (when so many others were forecasting a recession). A key part of consumer health is income growth. If income growth fails to match the increase in tariffs, spending will suffer.
Second, beyond the effects on consumer income, tariffs harm firms by raising input costs and creating uncertainty for businesses. A significant misunderstanding that most people have about U.S. trade is that it is mainly finished consumer goods. It is not. For example, as of November 2024, capital goods imports totaled $875 billion, while consumer goods imports totaled $731 billion.5 Consequently, tariffs would squeeze business profit margins and hamper investments.
So, how significant will the growth drag be? Using the lower-end consumer income estimate mentioned above ($1,500 per household per year), tariffs could shave 0.5% from annual GDP growth.6 While this might not sound like much for an economy that grew at an annual rate of 2-3% in nine out of the last ten quarters, why go out of our way to spoil the party? If anything, the model estimates of the drag on GDP growth likely understate the impact as the models do not quite capture the complexity of the modern economy, especially the U.S. economy.
The retaliatory effects will further hamper U.S. and global growth. Countries dependent on trade with the U.S., including Mexico, Canada, Singapore, and South Korea, will fare the worst. Retaliation is also likely. For example, in 2018, China raised tariffs on U.S. exporters, which affected agriculture and capital goods exports. The Chinese government retaliated against Trump's tariffs with tariffs that harmed various US industries, including agriculture. Consequently, the Trump administration expanded subsidies to farmers, spending nearly all of the tariff revenue from Chinese imports on farmer subsidies. Further, Chinese importers set up contracts with other sources. Today, China imports more corn from Brazil than the United States.7
Interest rates may go lower, not higher. While the dust may take some time to settle, short-term and longer-term interest rates will likely head lower once investors realize that tariffs impede growth. We also suspect the U.S. central bank will 'look through' one-time price increases and focus on negative growth risks—as long as inflation expectations remain in check. Meetings transcripts from the 2018-2019 FOMC meetings chronicle policymakers wrestling with the effects of Trump 1.0’s tariffs, and it was clear that the Fed was more concerned about growth than inflation. In an environment where core inflation was below 2%, the FOMC delivered three rate cuts in 2019.
The bottom line is that the tariff toll will land on consumers and businesses, reducing economic growth and raising downside risks for the U.S. and global economy.
To paraphrase Edwin Starr on [trade] war, 'What is it good for? Absolutely nothing.'