What Tariffs Mean for the Economy and Markets
The Trump administration's higher-than-expected “Liberation Day” tariffs shook markets and investors. Their aim appears to be the correction of trade deficits across US trading partners, but they’re expected to have far-reaching impacts on inflation, growth, and monetary policy. Our goal is to help investors make sense of the broader economic and market implications.
Now we know. For nearly three months, investors have struggled to position for tariff uncertainty. What products and countries would be impacted? Would tariffs primarily be a negotiation tool or a means to themselves? How might US dollar policy change? “Liberation Day” delivered some long-awaited clarity about the priorities of the Trump administration.
Surprisingly, the primary focus appears to be the correction of trade deficits broadly across all US trading partners. The reciprocal tariffs that were announced were not based on actual tariffs by US trading partners, but on the bilateral trade deficits for each country.
Importantly, the April 2 tariffs were much higher than market expectations, marking the fastest-ever lift in tariffs and setting the average US tariff rate at the highest level in a century (Figure 1).
Yet, they are also implicitly “maximum” tariffs with room for negotiation. We expect further developments around bilateral negotiations and trade arrangements in the coming weeks and months. In other words, following the market shock, going forward the risk is two-sided with both the potential for trade war escalation as well as reduction in trade barriers.
In response, US equities sold-off sharply the following day, with the S&P 500® Index down 4.8%, the Dow Jones down 4.0%, and NASDAQ down 6.0%. Bond yields declined and the USD fell sharply; the 10-year Treasury yield closed at 4.0%, the lowest level since mid-October while the Bloomberg dollar index declined 2.1%, the largest fall since its 2005 inception.
Tariffs’ Impact on Inflation and GDP
The initial market response based on the movement of medium-to-long-term yields suggests that the tariffs, on net, are being viewed as a negative demand shock by market participants. In other words, tariffs are expected to have a greater impact on economic growth than on inflation. More Federal Reserve (Fed) rate cuts have been priced in through year-end — with a June cut fully priced, 1.8 cuts priced by July, and nearly 3.8 by year end.
We see this in market-based medium-term inflation expectations, which have been reasonably well-behaved in recent weeks (Figure 2). Notably, they actually declined following the tariff announcement, suggesting investors see the inflationary impact of tariffs as short-lived. Two reasons could be behind this:
- Consumer wallets do not expand, so higher tariffs could cause a negative demand shock that eventually neutralizes the initial inflation effect.
- On a longer-term basis, the US policy of reshoring/friendshoring (which tariffs mean to accelerate) could lead to additional productive capacity globally, without a commensurate increase in demand. Longer-term, this would be disinflationary.
As for the short-term impact to GDP, a benign scenario would see the impact being somewhat mitigated by the likelihood of fiscal tariff revenue getting redistributed into the economy — and because exporters and currency could absorb some of the extra costs. Questions remain, however, about how much of the revenue will be redistributed, when that will happen, and what form this redistribution will take.
Policies to boost growth down the line may also help counter tariffs’ dampening effects on economic growth. These policies could include forms of financial deregulation, the possible creation of a Sovereign Wealth Fund, the expansion of AI-related spending, and yet-to-be determined investments in key industries, not to mention a fiscal package.
Sequential Forecast Changes
This leads us to the impact of tariff developments on our macroeconomic outlook. Since the start of the year, we have emphasized that risks to both sides of the Fed’s dual mandate have increased. Our March forecast maintained a baseline macro call of a slowdown but no recession, with real GDP growth slowing from 2.8% last year to 2.0% in 2025, driven primarily by softer consumer spending which has also slowed from 2.8% last year to 2.2% in 2025.
Relative to the March baseline forecast — which had already incorporated tariff assumptions amounting to a roughly 0.4-0.5 hit to core PCE in H2 2025 — we expect the April 2 tariffs to:
- Increase the end-2025 core-PCE inflation forecast by about 0.3 ppt to 2.9% year-over-year (YoY)
- Lower the Q4 2025 real GDP forecast by 0.2 ppt to 1.5% YoY
- Support the call for three rate cuts this year.
But the rationale for those cuts has become more ominous — no longer primarily a story of “cut because you can” but rather “cut because you have to.” While we still don’t have an outright recession in the forecast, we recognize the odds and would put them at 35-40%.
Recession Unlikely, But Real Risks Exist
While a soft landing is still what we expect, we’re not downplaying the significance of the announced tariffs. There are many difficulties in using tariffs to correct trade imbalances. Specifically, while tariffs may be intended to achieve positive outcomes — like protecting domestic industries, nurturing emerging industries, and reducing foreign dependence on critical goods in the event of a global supply chain shock — their broader consequences can extend beyond their original objectives.
Historical precedent is limited, but studies of the first Trump Presidency’s tariffs in 2018-2019 indicate a negative impact on real income and GDP.1 Estimates by economists and policy analysts have put the possible drag on economic growth as high as 2%, which would tip the US into recession. In the long run, tariffs may also reduce efficiency by insulating less competitive firms, misallocating resources, and discouraging innovation.
The retreat in markets and the accompanying plunge in consumer sentiment over the last few months suggest investors are aware of these risks. An extended period of negotiations lies ahead, with the trade war potentially intensifying in the short-term through retaliation before agreements are eventually reached. For example, China has already announced reciprocal 34% tariffs on US goods, a move which has spurred a further recalibration of global growth estimates at the time of this writing.
The Global Impact of Tariffs
How US tariffs play out in the rest of the world will be critical. Perhaps the biggest initial surprise was that tariffs were levied against emerging market Asian countries like Vietnam and Thailand — a clear message to deter simple Chinese trade diversion. Further ripple effects could come via currency weakness.
One wildcard for outperformance might be European equities. So far, the UK has been one of the few countries to “escape” with only the blanket 10% tariff. In fact, in terms of relative US market access, the UK has gained the greatest differential to US tariffs on China (Figure 3).
More importantly, the EU has one of the stronger hands to play in terms of potential retaliation, possibly through the imposition of retaliatory tariffs on US service exports to Europe. If the UK can remain “under the radar” and the EU play its relatively stronger hand to bring the US to the negotiating table, then the outperformance of European versus US equities year-to-date could continue.
Big Picture, Identifying and Managing Risk
It’s worth remembering that the April 2 tariffs are a continuation of efforts begun years ago under the first Trump administration. They were then sustained under the Biden administration, with the aim of improving US supply chain resilience, strengthening US security, and pursuing US strategic interests across the globe. The COVID pandemic, along with geopolitical tensions and conflicts in recent years, only heightened the importance of those objectives.
Policies that can successfully address these issues would be a net positive for the US in the long run. The White House has been clear that these aims have been their intended purpose. While the consensus view among analysts is that the policies so far would likely not deliver the desired outcomes, there is still much we don’t know.
As always, we’re focused on identifying early the vulnerabilities and risks to portfolios. Even a short-lived economic slowdown would imply lower bond yields, though US fiscal policy later this year could renew worries about long-term debt sustainability. Smaller US trade deficits and worries about return on US risk assets would also imply a weaker dollar once the short-term tariff convulsions are processed.
As we see how geopolitical dynamics play out and how consumers, corporations, and investors react, we’ll continue to refine and share our views. To stay up to date, view our latest macro and geopolitical insights.