Just How Inflationary Could Tariffs Be?

An election and a Fed meeting, but otherwise a totally normal kind of week…can we at least agree that Dems obviously can’t rig an election? I won’t rehash the FOMC Recap, but you can find it here. 

Last Week This Morning

• 10T: 4.25%
• 2T: 4.30%
• SOFR: 4.82%
• Term SOFR: 4.62%
• Bryce Young is a darn good QB when he plays top tier college teams like UGA or the NY Giants 

Tariffs

Last week was Markets Unchained as every possible Trump effect was fully priced in overnight. I get that the Republican sweep of Congress dramatically increases the likelihood of his policies passing, but I also remember 2017 and 2018 when Republicans had the same advantage and struggled with anything other than tax cuts.  

Mitch McConnell won’t be the Senate Majority Leader after December, but he has been clear that he is not stepping down from the Senate until his term expires in two years. I think there’s a really good chance that McConnell, and other traditional Republicans, will be looking for ways to rein in deficits, not widen them. You may recall that Trump and McConnell do not get along well, particularly after Trump made disparaging remarks about his wife. I think McConnell might relish the opportunity to be a thorn in Trump’s side if he believes a policy will result in great federal spending or debt. 

The one area where Trump can move quickly and without Congressional approval is tariffs. During the campaign, he has said he plans on instituting tariffs of 60% on Chinese imports. I decided to run the math so you don’t have to. You’re welcome. 

Inputs
PCE                                                       $20T
Core PCE                                             $17.4T 
Goods component of Core PCE    $7T  
Chinese goods imports                   $563B 

Chinese goods as a % Core PCE    $563B/$17.4T = 3.1%

Therefore, tariffs on Chinese goods will potentially impact about 3.1% of Core PCE. Contrast that with Shelter, which is about 20%, and I’m not sure tariffs are as inflationary as the headlines suggest.

Let’s do a thought exercise, though. What if Trump institutes tariffs of 60% on all Chinese goods? 

Core PCE would increase from 2.5% to 4.5%.  

Gulp. 

What’s the likelihood of that actually happening? That assumes:

• 60% tariffs are instituted on all $563B of Chinese imports
  • Highly unlikely that all goods receive the exact same tariff
• all price increases are passed directly on to buyers
  • companies will likely absorb some amount of the increase
• there is no offsetting decline in demand from higher prices
  • would you pay $1,600 for an iphone that was $1k yesterday? 

Fortunately, we have somewhat of a roadmap because Trump instituted tariffs in his first term.

• it took more than a year from when he took office until the first tariffs were implemented
• they were rolled out in phases over the course of 2018
  • Phase 1 was solar panels and washing machines. That’s it. And the tariffs were 30%-50%.
• Phase 2 actually hit far more countries than just China when he enacted tariffs on steel, leading to fears of a global trade war. 

A March 2018 Quinnipiac poll showed widespread disapproval of the tariffs, with only 29% of Americans agreeing with a "25% tariff on steel imports and a 10% tariff on aluminum imports" if it raised the cost of living…has that been a touchy topic lately? 

At their peak, tariffs were instituted on about $350B of Chinese goods over the course of about a year. They ranged from 10% - 50%. Remember when China cancelled US soybean orders?  

Back then, the market didn’t like the idea of an escalating trade war and Trump doesn’t like high interest rates. While his policies are inflationary, I think the market has overdone it in a kneejerk reaction to his win.  

I think the most likely outcome is that Trump policies make the last mile of inflation a little stickier, but falling shelter and a slowing job market will matter more than tariffs and tax cuts. 

Pop quiz - wanna guess what Core PCE averaged during Trump’s term before covid hit? 1.6% 

Bonus round – wanna guess who the most outspoken Senate opponent to tariffs was? 

Addison Mitchell McConnell III 

Rates

Markets have a 65% probability of a rate cut in December, which I think will be almost entirely dependent on the jobs report at the start of the month. I still think they cut and that the more likely outcome from the Trump win is a slower pace of cuts next year.

The T10 is testing that key 4.25% level. Right now, it’s the floor and I think it would take some really weak data to offset the risk on sentiment in the market.

The Week Ahead

CPI and PPI this week. Core CPI m/m is expected to come in at 0.3%, while headline CPI is expected to increase from 2.4% to 2.6%. Don’t freak out! This is the base effect from measuring against a rapidly plunging CPI this time last year (when it was dropping through 3.7%).