Capital Economics says the resulting surge in US inflation from the announced tariffs is going to 'come faster and be larger than we initially expected'

Independent global economics researcher Capital Economics (CE) says imposition of the Trump tariffs is going to result in a surge in US inflation that will come "even faster and be larger than we initially expected".

CE's chief North America economist Paul Ashworth says President Donald Trump’s decision to impose 25% tariffs on Canada and Mexico and an additional 10% tariff on China from this coming Tuesday, (with the only partial exemption for Canadian energy imports that will be subject to a lower 10% rate,) "is just the first strike in what could become a very destructive global trade war".

"Imports from the European Union will be hit within the next month or two and a universal tariff is coming in April. Since exports to the US account for around 20% of their GDP, today’s tariffs could plunge both the Canadian and Mexican economies into recession later this year. The resulting surge in US inflation from these tariffs and other futures measures is going to come even faster and be larger than we initially expected," Ashworth said.

"Under those circumstances, the window for the Fed [US Federal Reserve] to resume cutting interest rates at any point over the next 12 to 18 months just slammed shut."

Ashworth said ostensibly the tariffs are a means of applying pressure to stem the flow of fentanyl over the border but, since US seizures of the drug on the northern border amounted to a trivial 43lbs in the whole of last year, "it’s clear this is just a pretext for Trump to employ the International Emergency Economic Powers Act for the first time to levy tariffs".

"We don’t expect any deal that sees these tariffs removed any time soon, although it’s possible that more sectors could be added to the exemption. For a start, even domestic automotive sector costs will soar given that parts can cross the borders several times during the production process."

Ashworth said factoring in the imminent tariffs to be imposed on the EU and the universal tariff soon, "we suspect that US inflation will climb back above 3% later this year".

"Admittedly, since the new tariffs represent a one-off increase to the price level rather than an ongoing increase in the rate of inflation, at least as long as second-round effects are limited and inflation expectations remain well anchored, then the Fed doesn’t need to over-react," he said.

"Nevertheless, any chance of more interest rate cuts this year just died."

Ashworth said Canada (US$419bn), China (US$427bn) and Mexico (US$475bn) together account for 43% or US$1.3trn of the US$3.1trn value of goods imported into the US in 2023. Imports from Canada includes US$124bn of energy & minerals.

"The upshot is that this tariff announcement alone is already roughly three to four times the size of the original 25% imposed on slightly less than half of imports from China in 2018 and 2019."

Revenues from the tariffs could reach almost US$250bn per year, or 0.8% of GDP, Ashworth estimates.

"That could be a significant hit to the US economy if those revenues are used to reduce the federal budget deficit rather than recycling them into the economy by cutting taxes or boosting federal spending. US exporters will also lose out thanks to the stronger dollar, but retaliation by the other countries is likely to be modest, at least initially, as they seek to avoid inflaming tensions."

Snce goods exports to the US account for close to 20% of their GDP, the 25% tariffs represent an existential threat for both Canada and Mexico. But as China’s exports to the US account for less than 3% of its GDP now, an additional 10% tariff won’t have much of an effect on its economy, Ashworth said.

"Even allowing for a further depreciation in the Canadian dollar, we estimate that the 25% tariff on Canada will hit exports, investment and consumption, resulting in a 2.5% to 3.0% decline in GDP. The public finances are in good shape, however and the Bank of Canada has scope to cut interest rates by at least another 50bp. The upshot is that strong fiscal and monetary stimulus should limit the severity of any recession," he said.

"For Mexico, we suspect that the inflation generated by a weaker peso will prevent Banxico from cutting interest rates further, while fiscal policy needs to be tightened. As a result, even though we expect the hit to Mexican GDP to be closer to 2.0%, there is little scope to offset the tariff impact by loosening policy."

Ashworth said that Trump’s determination to force through substantial tariffs on supposed allies less than two weeks after taking office, and despite the opposition of some moderates within his administration, is "a clear indication that the gloves are off this time".

"In recent days Trump has also talked repeatedly about imposing substantial tariffs on the European Union and a growing list of products like steel and pharmaceutical products. His pick for Commerce Secretary, Howard Lutnick, also warned in his confirmation hearing last week that the European Union would be hit and that a universal tariff was coming as soon as April. How far this goes now is anyone’s guess. But the effective tariff rate on all US imports is already now up to around 10%, for the first time in more than 75 years, with plenty more to come," Ashworth said.