THE INFLATIONARY CONSEQUENCES OF TARIFFS / MACLEOD FINANCE

The inflationary consequences of tariffs

Tariffs not only raise consumer prices, but the budget deficit feeds a decline in purchasing power for the dollar unless the deficit is funded by an increase in consumer savings.

ALASDAIR MACLEOD 

This article details why the inflationary consequences of Trump’s tariff policies are severely underestimated, with important consequences for the dollar and the Fed’s interest rate policies. 

The implications are that an economy which is already tipping into recession is only seeing the beginning of its difficulties.

Inflation outlook is being badly misjudged

One area of speculation over the consequences of President Trump’s tariffs is the effect on consumer prices. 

Optimists comfort themselves by saying the cost of tariffs will be shared by foreign manufacturers, importers, wholesales, and retailers thereby minimising consumer price inflation.

Therefore, they say, with CPI remaining subdued and the economy trending into stagnation, interest rates can decline over the rest of the year. 

Undoubtedly, margins will be squeezed. 

But this view does not allow sufficiently for the higher costs faced by US manufacturers importing raw materials and other inputs not readily available in the US.

Furthermore, Trump falls into the trap of the broken window fallacy, by ignoring the consequences of destroying global supply chains. 

The obvious benefit of tariffs which he sees is the repatriation of manufacturing to the US. 

The hidden cost is in the destruction of supply chains, the consequences of which are far higher manufacturing costs than generally realised due to the loss of their efficiency at reducing manufacturing expense.

Additionally, the displacement of imported goods restricted by tariffs will lead to higher prices from US manufacturers through lack of imported competition. 

In an economy insulated from global production, domestic manufacturing falls very quickly behind global standards. 

Then there is the twin deficit phenomenon.

The relationship between the budget and trade deficits is being ignored by economic commentators. 

Nevertheless, twin deficits have often been observed in countries with low savings rates. 

But to understand why we must examine how a government budget deficit is funded.

If it is funded by an increase in consumer savings, consumer demand to that extent is withdrawn from the economy. 

The inflationary consequences of demand created by excess government spending are thereby neutralised. 

Alternatively, if consumers do not increase their savings, then excess government spending has nothing to offset its inflationary impact, and the general price level rises.

Nations whose populations habitually save have lower rates of consumer inflation. 

This is why in Japan, for example, the government can run large budget deficits with low levels of price inflation. 

It also follows that lower levels of consumer demand in savings-driven economies lead to greater product innovation in domestic production due to tougher competition for consumers’ spending.

Not only does domestic manufacturing become increasingly efficient, but in doing so it displaces competition from imports, and is also the basis of successful exports to other nations. 

Clearly, it is the difference in savings habits between nations which leads to trade imbalances. 

It is not, as Trump believes unfair competition.

Consequences of the twin deficit problem

Having discouraged savings through buying into the Keynesian savings paradox, the US and its UK Anglo-Saxon behavioural twin cannot run a budget deficit without giving rise to a trade deficit in manufactured goods. 

This is why we observe the twin deficit phenomenon in these nations.

If Trump really wants to cut the trade deficit, he must cut the budget deficit and encourage US citizens to save — neither of which his administration appears to understand. 

Instead, by pushing for a more competitive (lower) dollar and lambasting the Fed for not reducing interest rates he falls further into the Keynesian trap.

Future budget deficits will therefore have a significant inflationary impact, particularly if the savings rate doesn’t improve and imported goods are tariffed out of the US economy. 

Not only will the budget deficit continue to fuel inflation by stimulating consumer spending, but it will be against a background of a restricted supply of goods from abroad. 

In other words, Trump’s tariff policies will undermine the purchasing power of the dollar more dramatically than generally realised.

Trump’s tariffs also come at the time when commercial banks fear the risks of private sector lending. 

Along with Basel 3 discouraging lending to small and medium size enterprises, banks are channelling their lending into short-term government debt (Basel 3 preferred). 

They are funding the Federal deficit while depriving the private sector of credit. 

The US economy is already entering a slump through lending starvation.

The consequence of a slump will be larger budget deficits as revenues undershoot and welfare spending commitments increase. 

With tariffs restricting the supply of imported goods, accelerating inflation is the certain outcome.

That is the background to interest rates. 

If the Fed is to protect the dollar from devaluation, it must retain a high interest-rate stance. 

And it is this, perhaps, which financial markets are beginning to sense. 

For in all their turmoil, it is noticeable how the dollar is weakening and bond yields remain high.