Tariffs will impact the economy … and so will uncertainty
The April 2025 Economics Insider highlights how the newly announced US tariffs will likely impact inflation and growth, with uncertainty also weighing on sentiments in the short term
Tariffs have been dominating headlines as the new US administration drives sharp policy changes. In April, the United States announced a slew of reciprocal tariffs on almost all of its trading partners.1 Goods from China will now attract a cumulative tariff hike of 125%. Most other countries and the European Union will face 10% tariffs for a period of 90 days to enable trade negotiations. Tariffs worth 25% are already in force against Mexican and Canadian goods, with some exemptions2—energy imports from Canada will attract a lower rate of 10%. Tariffs on countries, as a whole, are in addition to product-specific ones such as 25% tariffs on all aluminum and steel imports into the United States.
These measures will raise the average US tariff rate to levels not seen since the early part of the 20th century.3 And it will not be without retaliation, with China announcing a cumulative 84% tariff hike on US goods.4 So, what will be the overall impact of all this on the US economy? In the near term, these tariffs will likely raise inflation without increasing domestic production. This, in turn, may slow the pace of rate cuts by the Federal Reserve (Fed) even if the inflation turns out to be transitory.5 Second, as consumers anticipate inflation to rise, they may frontload some spending in 2025.6 But, as rising prices hit purchasing power, consumer spending growth will likely slow next year.7 Finally, what is also worrying, now, is the lack of clarity on the final tariff framework itself. This uncertainty is starting to weigh on consumer and business sentiment.8 Key equity indices have declined, and the US dollar has weakened since February 2025.9
Tariffs will likely lead to higher inflation
A tariff is a tax paid by importers who will likely pass on at least some part of this added cost to their consumers. Even if the imported good is an intermediate product, the impact of a tariff gradually filters through the value chain into the final product itself. This is not yet evident in the inflation data, so far, as some of these tariffs came into force only in March. However, it is likely that some of the increase in goods inflation in the first two months of 2025 can be attributed to upcoming tariffs.10
Worries about tariffs are forcing inflation expectations up. The University of Michigan’s one-year-ahead inflation figure surged to a 28-month high of 4.9% in March.11 The Federal Open Market Committee, in its median view in March, expects core personal consumption expenditure inflation—which excludes food and energy prices—to be 2.8% this year, up from its projection of 2.5% a quarter back.12
A rise in inflation may turn out to be transitory, especially if a onetime tariff hike slows aggregate demand growth in the economy, and inflation expectations remain anchored.13 But, a series of tariff rate increases, including responses to trade partners’ retaliation, may lead to a more sustained increase in consumer prices over time. Transitory or not, concern surrounding higher tariffs is making the Fed more cautious in its interest rate path.14 This is evident from the FOMC’s quarterly projections: In March, the median view of committee members was just 50 basis points of interest rate cuts in 2025, half of what the median view was six months back (figure 1).15
Consumer spending growth will likely slow due to tariffs
In 2024, the average tariff rate in the United States was 3.3%. Yet, this rate is set to increase this year if recent tariff hikes are made permanent. Deloitte economists, in their baseline forecasts, have modeled an increase of five percentage points in the average tariff rate this year onward.16 This scenario assumes that there will be rollbacks on certain tariffs as countries engage with the United States for trade deals. As tariffs rise, consumers will expect prices of goods—especially durables like cars—to increase. In such a scenario, they will frontload some spending this year. However, as rising inflation dents their purchasing power, consumers will cut back, leading to lower spending growth in 2026 (figure 2).
If the average tariff rate rises by 10 percentage points—double of what is assumed in the baseline—the impact on consumer spending and wider economic growth will likely be more severe (figures 2 and 3). The average tariff rate hasn’t been that high—as assumed in this downside scenario—since World War II.17 For reference, 25% tariffs on Canada and Mexico, along with 20% additional trade tariffs on China would raise the average tariff rate by just under 10 percentage points.18 With inflation being higher in this scenario compared with the baseline, the Fed will likely hold off on any rate cuts till 2026.
The reciprocal tariffs announced on April 2, 2025, would, however, push the average tariff rate even higher. Estimates by the Budget Lab at Yale University put this increase in the average tariff rate at over 20 percentage points.19 That’s twice the increase in the tariff rate assumed in the downside scenario and will push the rate to levels last seen in 1909.20 Such a high average tariff rate is expected to have a larger impact on inflation than in the baseline and downside scenarios mentioned above. This, in turn, will impact consumers’ purchasing power by more than expected, thereby leading to lower growth in consumer spending and the wider economy than in the scenarios highlighted in figures 2 and 3. Higher inflation and lower growth will also make the Fed’s work tougher, given its dual mandate of stable prices and maximum employment.21
It’s worth noting that the scenarios in figures 2 and 3 also include the impact of federal government spending cuts and tighter immigration (both of which are more severe in the downside scenario).22
Reshoring of production in the United States will raise costs
While tariffs may lead to some reshoring of manufacturing back to the United States, the economic benefits will take time to materialize. Supply chains, today, are spread across the globe. The North American auto industry is a good example, with individual components crossing the US border multiple times (to Mexico and Canada).23 Yet, even in this hub, not all components (about 15,000 of them) are produced in the region itself; some may come from as far as Asia.24 To replace such hubs and concentrate almost all production in the United States will cost money and time.
Reshoring may not turn out to be competitive for the American economy. Typically, in global value chains, high-value manufacturing takes place in advanced economies, with low-labor-cost production being done in emerging market economies.25 This ensures that advanced economies with skilled labor tap into the high-value-added part of a global value chain. Moreover, these value chains not only include manufacturing but services like research, design, computer coding, and marketing. And it is advanced economies like the United States that add the most value through these high-skilled services.26 Hence, trade through these value chains have benefitted upper-middle and high-income countries over the years.27 If low-value manufacturing is reshored to the United States, overall costs for production will likely increase for American firms, leading to inefficient allocation of economic resources.28
Uncertainty has added to worries
Apart from the proposed tariffs, what is worrying is the uncertainty about the final structure of said tariffs and wider policy changes29 (figure 4). Since the first tariffs were announced on Canada and Mexico in February, there have been extensions and exemptions. And even after the reciprocal tariffs were announced, it is unclear whether some of these tariff rates will stand, as the US administration has kept the door open for trade deals with trading partners.30 This uncertainty, in turn, will weigh on consumers and businesses.
Consumer sentiment, as measured by the University of Michigan, fell to a 28-month low in March, with people being wary about the impact of tariffs on their future economic prospects.31 Financial markets too appear spooked. The S&P 500 is down by 17.4% (till April 4) since its peak in mid-February, while the tech-heavy NASDAQ shed 22.3% over the same period.32 Equity markets were hit the most on April 3 and 4, the days right after the announcement of reciprocal tariffs with the S&P 500 shedding 10.5% and the NASDAQ easing by 11.4%. Bond yields, too, have fallen, and the US dollar has been losing ground to major global currencies since February.33 It is likely that retaliation by trade partners will put further strain on financial markets.
Many businesses too, are feeling the pinch of effects from shifting trade policy and rising uncertainty. According to the Institute of Supply Management, new orders in the manufacturing sector fell in February—the first decline in four months.34 And optimism among small businesses has also declined, according to The National Federation of Independent Business.35 For manufacturers, the lack of clarity about a final tariff structure makes it hard for them to commit to investment decisions or any other decisions about their supply chains, especially those that are spread across multiple countries. It will get even harder if retaliation by US trading partners upend long-established supply chains and prolong global business uncertainty.
If this continues, it may dent business investment in the economy and wider GDP growth.
