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This edition was written by Alex Conner, Tristan Loa, Georgia Nabors, and Louise Sheiner.
Adrien Auclert of Stanford, Matthew Rognlie of Northwestern, and Ludwig Straub of Harvard use a simple open-economy model to show that a temporary tariff shock is likely contractionary because, at least in the short run, it is easier for consumers to delay consumption and for U.S. trading partners to substitute away from U.S. exports than for U.S. consumers to substitute away from imports. In the absence of retaliation, temporary tariffs improve the U.S. trade balance, but with retaliation the decline in U.S. exports likely leads to a worsening of the trade balance. Monetary policy may be able to offset the contractionary effects of tariffs, but that would come at the cost of a weaker currency and higher inflation. The optimal temporary tariff is much lower than that implied by standard optimal tariff theory, which seeks to identify the permanent tariff rate that balances the long-run efficiency losses from distorting free trade against the gains from exchange-rate-driven reductions in import prices.
Modern manufacturing often relies on global value chains (GVCs)—networks that divide the production process into stages that occur in different countries. Using establishment-level data linking exports and imports to the production process, Aaron B. Flaaen of the Federal Reserve Board and co-authors examine value chains in which inputs from a foreign country are used in U.S. production and the resulting products are exported abroad. They find that flows along these chains have increased significantly: imported inputs rose from 13 cents of every U.S. manufacturing export dollar in 2002 to 20 cents in 2017, substantially higher than aggregate data suggest. Further, they find that a shorter geographical distance between input and output markets substantially increases GVC flows, indicating complementarities between source and destination countries. This effect is even greater for “round trips”—linkages in which U.S. firms import inputs from a country and then export products back to the same country. Regional trade agreements between the input source, the U.S., and the export destination increase GVC flows.
Despite low unemployment, moderating inflation, and higher real income than in 2019, consumer sentiment at the end of 2024 was unusually low, below the levels at the onset of the pandemic and comparable to those during the Global Financial Crisis. Using data linking household survey responses to verified spending, Sinem Hacıoğlu Hoke of the Federal Reserve Board and co-authors find that low sentiment primarily reflected households’ perception that incomes have not kept up with prices. Sentiment was lower among respondents who overestimated inflation and among those who reported working longer hours or taking on additional jobs. Nonetheless, most households—including those reporting lower incomes—had higher inflation-adjusted spending in 2024 than in 2019. These findings suggest that consumer sentiment has become a weaker indicator of consumer behavior than in the past.
“Over the medium term, tariffs are set to have an unambiguously recessionary effect, both for countries imposing restrictions and those receiving them. The costs are particularly high when exchange rates fail to absorb tariff shocks, and some evidence suggests exchange rates have become less effective in this role," says Piero Cipollone, Member of the European Central Bank's Executive Board.
"...The...long-term shift driven by fragmentation might be the gradual transition from a U.S.-dominated, global system to a more multipolar one, where multiple currencies compete for reserve status. For example, if the long-term implications of higher tariffs materialize, notably in the form of higher inflation, slower growth and higher U.S. debt, this could undermine confidence in the U.S. dollar’s dominant role in international trade and finance. Combined with a further disengagement from global geopolitical affairs and military alliances, this could, over time, undermine the 'exorbitant privilege' enjoyed by the United States, resulting in higher interest rates domestically.
...The lesson from the 1930s is that international coordination is key to avoiding protectionist snowball effects, where tit-for-tat trade barriers multiply as each country seeks to direct spending to merchandise produced at home rather than abroad. In order to avoid this, the G20 countries committed to preserving open trade could call an international trade conference to avoid beggar-thy-neighbor policies and instead agree on other measures, such as macroeconomic policies that can support the global economy in this period of uncertainty and contribute to reduce global imbalances.”
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