Doom loop: Stagflation is the best scenario a tariff-hit US can expect

The US President’s attack on free trade is truly extraordinary in its scope, scale and lack of nuance. The weighted-average tariff will likely climb to 25% or more of the value of imports this year, from less than 3%. This increase amounts to more than 10 times what Trump did in his first term.

The impact will be devastating. Over the next six months, annualized inflation will likely climb to nearly 5%, as tariffs boost import prices. Plus, domestic producers shielded from competition may raise their prices as well.

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Meanwhile, demand will decline. Businesses will delay investments amid uncertainty about the duration and breadth of tariffs and the degree of foreign retaliation. People will cut back on spending as they adjust to what amounts to a tax hike of $600 billion or more. This is likely even if the US Congress offsets tariffs with tax cuts elsewhere—because there will be a considerable lag, and because low-to-moderate-income families, which tend to spend more of their income, will be hurt by tariffs more than helped by income-tax relief.

Worse, the economy’s ability to grow will be impaired. Deportations and a collapse of immigration will undermine the supply of workers, while productivity gains will slow. This will cut the sustainable rate of real output growth to about 1%, from 2.5% to 3% last year.

All told, stagflation is the optimistic scenario. More likely, the US will end up in a full-blown recession accompanied by higher inflation.

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What, if anything, can the Fed do? It usually fights inflation with higher interest rates, which would deepen any recession. Chair Jerome Powell has suggested that it might not need to do so if price increases are temporary and don’t affect expectations of future inflation. This has encouraged investors somewhat, implying that the Fed will focus more on maintaining growth. Yet there’s ample reason to doubt that the Fed’s conditions will be met.

First, inflation has long been running above the central bank’s 2% target. If it does so for the fifth consecutive year and even accelerates, there’s a big risk that inflation expectations will get unanchored.

Second, the type of shock matters. Ones that hurt productivity, as US tariffs will, may have longer-lasting effects on inflation and expectations. Consider the twin oil-price shocks of the 1970s: Inflation proved persistent despite two recessions. Only by forcing the economy into a much deeper downturn, with short-term interest rates reaching nearly 20% back then, could the Fed get things under control.

Third, the Fed’s own actions influence expectations. If people think the central bank is ignoring inflation pressures to focus instead on the growth side of its mandate, that perception alone could lead them to anticipate more inflation.

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Inflation expectations play a crucial role in determining the cost of fighting actual inflation. When they remain well-anchored, as in the past five years, the Fed can manage without pushing unemployment up too high. But if they rise, the sacrifice ratio increases sharply. In circumstances such as the 1970s oil shock, for example, the unemployment rate may need to rise 2 percentage points above its long-run level to reduce inflation by 1 percentage point in one year. In other words, recession becomes the Fed’s only option.

This asymmetry means the Fed will have to be very careful as the US economy struggles. Any easing of monetary policy that stokes inflation expectations will necessitate a much harsher and costlier tightening later. Hence, investors may be too optimistic about the likelihood of central bank support. On the contrary, the balance of risks and high level of economic uncertainty justify a slower response.

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The combination of slower growth, higher inflation and a stubborn Fed will create a no-win situation for stocks. If companies pass on the cost of higher imports to consumers, inflation will be more persistent and the Fed less friendly. If they can’t, profit margins will shrink and earnings will underwhelm. There’s also the risk of foreign tariff retaliation.

For bonds, the main issue will be the trajectory of short-term interest rates. Currently, markets are pricing in over a 100 basis points of easing this year. I think that’s likely (and justified) only in the event of an actual economic downturn. This isn’t 2019, when below-target inflation allowed the Fed to cut rates as ‘insurance’ against a recession. Nowadays, the world’s most powerful central bank has a lot less room for manoeuvre . ©Bloomberg

The author is a Bloomberg Opinion columnist.