Trump’s New Tariffs Hit a Different Economy

The macro conditions that cushioned the first trade war no longer exist, and that could determine how the latest salvo plays out.

Donald Trump’s trade war — unleashed in his first administration but renewed with enhanced fury at the outset of his second administration — threatens the rules-based international trading system built in the wake of the Second World War. That system was instrumental in unwinding the beggar-thy-neighbour trade, financial and economic policies responsible for the economic carnage of the 1930s — particularly short-sighted tariff policies, especially the disastrous Smoot-Hawley tariff legislation in the United States. Smoot-Hawley will forever live in infamy in the annals of economic policy making.

Trump’s use of section 338 of that bill against Canada in the most recent skirmish in his trade war is perhaps the clearest indication of his intention to disrupt international economic and geopolitical relations. It also raises fresh concerns about the consequences of the uncertainty generated by the disruptive trade and tariff policies of his administration.

Three considerations warrant careful assessment to gauge the impact of this latest trade shock and how best to respond to new tariffs in the long term. The first of these considerations is the current macroeconomic conjuncture, or the prevailing state of the economy. There is a critical difference in this regard between the first round of Trump tariffs, now almost a decade ago, and the latest salvo against the international trading system.

At the time of the first Trump administration, the United States was still recovering from the so-called “Great Recession” following the global financial crisis; output remained below potential and unemployment remained above its natural rate. Given this slack in the economy, inflation was quiescent and, perhaps more importantly, long-term inflation expectations were firmly anchored on the US Federal Reserve’s (the Fed’s) implicit two-percent inflation target. Those factors, combined with expansionary tax cuts, masked the negative effects of tariffs; indeed, however damaging these tariffs were from a long-term perspective, they likely accelerated the return to full employment by switching demand from foreign to domestic goods.

None of these conditions hold today. In contrast to the macroeconomic conjuncture a decade ago, actual output currently exceeds potential, while unemployment is broadly at its natural rate. Inflation — which had spiked in the pandemic but was steadily converging on the Fed’s inflation target prior to Trump’s re-election — remained stubbornly above that target through 2025 as the tariff war resumed. More recently, inflation has jumped significantly in the wake of the US war with Iran, which has led to significantly higher oil prices. Inflation expectations, meanwhile, have risen since the start of hostilities at the end of February.

To read the full article as it was published by Center for International Governance Innovation, please click here.