The week ahead: six questions on tariffs answered

The tariffs announced by US President Donald Trump last week are essentially the worst-case scenario –and sometimes even worse than economists and financial markets were expecting. That’s why equities have sold off so sharply. The S&P 500 and FTSE 100 are both down by about 10%. 

There’s obviously still a huge amount of uncertainty, but here I’ve tried to answer the top six questions that I’ve received in the last few days. 

1. Are these tariffs a negotiating gambit?

I won’t claim to have any more insight into this than anyone else. We’ve seen tariffs used as a negotiating tactic, for example with Mexico and Canada, so it wouldn’t be surprising if there were a series of bilateral negotiations to reduce tariffs over the next few weeks. But, we also know that Trump has long been a fan of tariffs. To achieve his aim of reshoring manufacturing, tariffs will need to be large and permanent. 

2. What’s the impact on the UK?

The direct impact on the UK is relatively small. Only about 15% of goods exports (about 2% of GDP) go to the US. Simple models suggest a 10% tariff would knock about 0.1ppts off GDP. The higher tariff on vehicles probably knocks off another 0.1ppts. 

However, we were never particularly worried about the impact from direct tariffs. That’s why a UK/US ‘trade deal’ won’t do much to cushion the blow if it ever materialises. 

The bigger impacts come from the huge increase in uncertainty, which has already damaged growth, and the significant reductions in growth in the US and EU that will come off the back of the tariffs. Slower growth in the US and EU means slower growth in the UK. 

All in all, the total impact will probably be up to a 0.5ppts hit to UK growth. The UK is predominantly a services economy, which are immune to the tariffs. As long as consumer spending continues its recent positive trend, then we should avoid slipping back into recession. At the moment, we are likely in scenario two of the three tariff scenarios the OBR set out last month. If countries retaliate, then we could easily find ourselves in scenario three.

3. How will this affect interest rates?

That depends on if and how countries retaliate. If the US imposes unilateral tariffs, then that will be negative for growth in the UK and EU, which should, all else being equal, lower inflation and allow the Bank of England and the ECB to cut interest rates more aggressively.

However, if countries impose retaliatory tariffs, then it would mean even weaker growth combined with higher inflation. That’s a trickier situation for central banks and government to deal with. For now, financial markets have gone from expecting two more rate cuts this year to three more. 

We wouldn’t rule out bigger cuts if tariffs stay as they are and there is limited retaliation. 

4. Has this wiped out that fresh £10bn of fiscal headroom?

Not necessarily. Obviously, weaker growth will lead to lower tax receipts and more borrowing. If the OBR judges that there has been a permanent reduction in global trade, then that will lead to weaker productivity in the future. This would have a profound upward impact on borrowing. 

However, gilt yields have already fallen by almost 40bps, which will offset some of the negative impact from lower growth on the budget deficit. We wouldn’t go so far to say the new £10bn headroom has been wiped out, but it probably isn’t far off. 

5. Is the UK a relative winner from this?

If you count being beaten one-nil rather than two-nil winning, then maybe. The theory is that if the UK has a 10% tariff and the EU a 20% tariff or worse, then there will be an incentive to produce goods in, or at least channel goods through, the UK. 

In theory this might work, but it smooths over all the difficulties in producing goods in the UK in the first place. The UK manufacturing sector has been the worst-performing sector of the economy over the last few years. A 10% tariff arbitrage isn’t enough to overcome this. And to the extent that goods are channelled through the UK (this is much easier said than done), the economic benefit to the UK would be tiny. Some UK manufacturers may get a bit of a boost relative to their EU counterparts, but the benefit is likely to be small. 

6. What’s the best- and worst-case scenarios?

The best-case scenario is probably that these tariff announcements are an opening gambit and will be reduced over the coming weeks and financial markets recover the worst of their losses. 

The worst-case scenario is probably that these tariff announcements are still an opening gambit, other countries respond in kind, resulting in a tit-for-tat trade war that spills over into services, severely reducing growth, boosting inflation and preventing interest rates from falling. A recession in the US, UK and EU isn’t our base case, but the risks have surely risen sharply in the last week. 

Ultimately, businesses are resourceful and will adapt to the new conditions. What’s more, given large tariffs on almost everyone, there will be very little price competition with importers. That means American consumers might just end up paying more for everything. There’s obviously, a great deal of uncertainty, but at the minute we are probably looking more at a modest hit to growth rather than another recession.