Tariffs

President Trump used successfully and extensively in 2018-2019 in trade negotiations with China.

Those tariffs created little discernible macroeconomic consequence:

• inflation remained stable or even declined
• GDP growth continued to perform quite well despite the Fed’s hiking cycle.

It is therefore reasonable to expect tariffs once again to be a primary tool.

Tariffs and Currency Offset

To what extent do currencies adjust to offset changes in international tax regimes?

A recent rigorous theoretical treatment and literature review is given, for instance, in Jeanne and John (2024).

Currencies offset changes in tariffs because tariffs improve the trade balance.

• This puts upward pressure on the currency.

But currencies might also adjust because:

• nations’ central banks adjust interest rates to offset inflation and changes in demand or
• end-supply is determined by comparative advantage and end-demand by preferences, and currencies adjust to offset changes like taxes or
• the growth prospects of the tariffing country improve relative to the tariffed country, attracting investment flows (so long as tariffs do not exceed “optimal” levels).

To illustrate the mechanism simply, let:

• px be the price of a good charged by (foreign) exporters, denominated in their own currency
• e the exchange rate (dollars per foreign currency unit)
• τ the tariff rate

Then the price paid by (American) importers is:

pm = e(1+ τ ) px

Suppose we begin with e=1 and τ=0.

The government imposes a 10% duty on imports but the foreign currency depreciates by 10% as well. Then the price paid by importers becomes:

pm= 0.9(1.1) px
=0.99px

In other words, the exchange rate move and the tariff almost completely offset each other.

The after-tariff price of the import, denominated in dollars, didn’t change.

If the after-tariff import price in dollars doesn’t change, there are minimal inflationary consequences for the American economy (but not so for the exporting country).

Underlying this simple example are a number of assumptions which must be made clear:

1. The exchange rate must move by the right amount.
2. Primitive and intermediate value added in final exports originate predominantly in the exporting nation.
3. Passthrough from exchange rates to exporter prices px is complete.

Importantly, since imports are often invoiced in USD, the exchange rate doesn’t automatically affect.

Instead, a strengthening in the dollar improves exporter profit margins if exchange rates do not passthrough into prices.

4. Passthrough from wholesale import to retail consumer prices is complete.

These assumptions may not hold perfectly, in which case there is room for more volatility in prices, international trade and markets.

To the extent there are no meaningful changes to …, then there will be no rebalancing of trade flows as a result of the tariffs.

If imports from the tariffed nation:

• become more expensive, then there will be some rebalancing of trade flows but also higher prices.
• do not become more expensive because of currency offset, then there’s no incentive to find cheaper imports.

One must choose between higher prices and rebalancing trade.

Revenue is an important part of this story, as discussed below.

Inflation

In principle, tariffs can be noninflationary.

The macroeconomic data from the 2018-2019 shows the tariffs operated pretty much as described above.

The effective tariff rate on Chinese imports increased by 17.9 percentage points from the start of the trade war in 2018 to the maximum tariff rate in 2019 (see Brown, 2023).

As the financial markets digested the news, the Chinese renminbi depreciated against the dollar over this period by 13.7%, so that the after-tariff USD import price rose by 4.1%.

In other words, the currency move offset more than three-fourths of the tariff, explaining the negligible upward pressure on inflation.

Measured from currency peak to trough (who knows exactly when the market begins to price in news?), the move in the currency was 15%, suggesting even more offset.

Measured CPI inflation moved from slightly above 2% before the start of the trade war to roughly 2% by the armistice.

Measured PCE inflation went from slightly below the Fed’s target to further below the Fed’s target.

There were cross-currents like the Fed’s tightening cycle at the time, but any inflation from this trade war was small enough that it was overwhelmed by these cross-currents.

This explains the Trump camp’s view that the first U.S.-China trade war was noninflationary.