The authors belong to the Shadow Open Market Committee, a group of private sector economists founded as an “outside watchdog” of the Federal Reserve’s setting of monetary policy. The SOMC advocates for sound monetary policy guided by systematic rules whose primary objective is stable and low inflation. Click here to read about its contributions over the past fifty years.
President Trump’s aggressive imposition of tariffs, along with threats of further tariffs, as a policy lever to achieve other objectives is a misguided and harmful public policy. Trump seemingly forgets that the tariffs assessed during his first term harmed economic performance and global trade, and presumably will have the same effects this time. So far, he has imposed tariffs on Mexico and Canada and abruptly postponed them under unspecified conditions, assessed additional 10 percent tariffs on all imports from China, and imposed 25 percent tariffs on all imports of steel and 10 percent on aluminum imports. These actions will dampen economic activity in the United States and abroad, push up product prices for US consumers, and do little to achieve national security objectives.
Trump’s erratic and unpredictable orders create uncertainties that scramble business operations and their decisions to invest and hire. These distortions work against economic performance and employment. They undercut the United States’ stature and role as a global leader. Moreover, we worry that Trump’s aggressive central-control tendencies may lead to other actions that compound the costs of the tariffs.
Based on his expressed preference for lower interest rates and a weaker US dollar, Trump may try to influence the Federal Reserve to lower interest rates. At minimum, this would increase the difficulty of the Fed’s job of achieving its dual mandate of 2 percent inflation and maximum employment. If this happens, we encourage the Fed to rebuff all pressures to lower rates and continue to focus its monetary policy on achieving its dual mandate.
There also is a risk that Trump may direct the US Treasury to intervene in foreign-exchange markets, which would also be unfortunate and could prove costly.
Diluting the benefits of free trade
The benefits of international trade and the economic costs of tariffs are well understood by the economics profession and are measurable to consumers and businesses. Global trade leads nations to produce and export the goods and services in which they have a comparative advantage and benefit from importing products that are produced more efficiently abroad. History shows clearly that international trade is the basis for higher standards of living and prosperity.
US-imposed tariffs are a tax on businesses that import goods. Whether these taxes squeeze business margins, are passed on as higher prices to consumers, or are absorbed by the foreign businesses that export goods to the United States depends largely on the price sensitivity of demand for the imported goods and how changes in the dollar exchange rate affect the relative prices of the goods. One way or another, tariffs weaken economic activity and global trade.
The increase in prices of tariffed goods has a one-time impact on the general price level but does not generate persistent inflation. Inflation occurs either when tariffs are raised persistently (which generates a persistent rise in the general price level) or when they are accommodated by easier monetary policy that generates excess demand. However, even a one-time boost to the inflation measures during a period when inflationary expectations are elevated may be troublesome.
The goal of tariffs is to raise the price of imported goods, which leads consumers to buy domestically produced goods, which moves production and jobs back home. But producing those goods in the United States tends to be more costly or involve distortions in production and supply chains that result in inefficiencies. Any production and jobs that eventually move back to the United States as a consequence of the tariffs will be a small fraction of the job losses and harm the tariffs impose on US industries and workers. That was the case of the tariffs imposed during Trump’s first term, when real GDP growth and business investment slowed and employment in manufacturing flattened.
How the Trump team sees tariffs
The Trump team sees trade, the US dollar, and tariffs differently. They view the persistent trade and current-account deficits as disequilibria that stem from the US dollar being the world’s reserve currency, which requires foreigners to hold large portfolios of dollars. According to the Trump team, these US deficits keep the dollar above some equilibrium value, putting US manufactures at a disadvantage and encouraging outsourcing. Its perception is that the United States provides a “security blanket” to allies and conveys other benefits to them, so it is appropriate for the United States to extract fees in return.
While wanting to preserve the US dollar’s reserve-currency status, Trump may consider different initiatives that would lower the value of the dollar that are particularly worrisome. Some of these initiatives have been suggested by Stephen Miran, Trump’s appointee to chair of the Council of Economic Advisers. They may include coordinated efforts with other nations to lower the US dollar (by intervening to appreciate those nations’ currencies), possibly by direct foreign-exchange intervention by the Treasury and the Fed, and by adjusting US monetary policy (easing) to achieve a desired currency level. Trump frequently lashed out at the Fed during his first term.
The administration relies on this line of thinking to legitimize tariffs. These perceptions seemingly overlook the significant benefits the United States gains from its reserve-currency status, including the reduction of costs and lack of currency risks of international transactions denominated in US dollars, and the financial inflows into dollars that keep interest rates (and US government debt-service costs) lower than they would be otherwise. These perceptions understate the potential costs of tariffs stemming from foreign retaliation to tariffs and distortions that tariffs would have on global production and distribution networks. They also overlook the importance of maintaining allies.
Trump also views tariffs as a potential significant source of revenues, which is misguided. His fanciful admiration of President McKinley’s reliance of tariffs at the turn of the nineteenth century completely misses the context, which has changed 180 degrees. In McKinley’s era, there was no income tax and no Social Security taxes on wages, and tariffs were a key source of revenues that supported a small government. US firms were just reaching maturity during the second Industrial Revolution and the United States depended heavily on capital inflows from Europe to finance development. The British pound was the world’s reserve currency.
Today, US industry and its economy dominate the world while many nations’ economies suffer from anti-growth policies and are in the doldrums. The US dollar is the world’s reserve currency. Revenues from tariffs are only 1.5 percent of total federal government receipts. Raising tariffs now would backfire. Combined with foreign retaliation, tariffs pose a larger drag on economic activity than taxes, and the weaker economic growth would depress total tax receipts more than revenues from tariffs would boost them.
The current environment for imposing tariffs is far different and less forgiving than in 2018, when Trump imposed tariffs in his first term. In 2018, global economies, particularly those of China and Europe, were enjoying healthy growth. Currently, while the United States’ economic performance is healthy, the economies of other leading nations are decidedly weak, making them vulnerable to the negative impact of tariffs. China’s domestic economy is notably soft, as the unraveling of its government-generated excesses in real estate has forced households to save rather than spend, depressing domestic demand, and has devastated local government finances and saddled them with massive debt. Europe’s economies have stumbled badly as high taxes, excess regulations, and failed energy policies have flattened growth and diminished potential. The United Kingdom continues to struggle. Japan’s growth is very weak, despite influxes of foreign labor and healthy productivity gains.
Despite their weakened economic conditions, these nations express willingness to retaliate against Trump’s tariffs. This accentuates the lose-lose consequences of imposing tariffs.
Trump’s threats to impose tariffs on Mexico and Canada are particularly misguided. Mexico and Canada are the United States’ two largest trading partners and are valuable allies. Roughly 80 percent of each nation’s exports go to the United States, and tariffs will harm them substantially more than they harm the United States. The relative harm to our trading partners will appreciate the US dollar, which will impose the higher costs on the exporters to the United States and mitigate the effects of the tariffs in the United States. Their promised retaliation will accentuate the economic harm.
The United States imports roughly $480 billion from Mexico, its largest trading partner, and $440 billion from Canada. A large portion of imports from Mexico are intrafirm transfers, primarily within US-based firms, involving autos and parts, industrial and electrical machinery, and agricultural produce. The cross-border trade provides significant benefits to both US and Mexican companies, their workers, and US consumers. Among the imports from Canada is $100 billion in crude oil and natural gas. US refiners are specifically geared to refine the heavy crude from Canada, and consumers will pay the price for any petroleum tariffs. The United States also imports significant amounts of steel and aluminum from Mexico and Canada that would be subject to Trump’s tariffs.
History shows that tariffs imposed in an attempt to force production and jobs into the United States don’t work and instead prove costly. In Trump’s first term, the positive economic responses to Trump’s thrust toward deregulation and the Tax Cuts and Jobs Act of 2017 were reversed by the 2018 tariffs that slowed growth and employment.
Inflation, the dollar, and monetary policy
As the Trump-initiated tariff war unfolds, the Federal Reserve remains committed to its 2 percent inflation target but has struggled to achieve it. Solid economic growth benefiting from higher productivity gains and healthy increases in employment has kept the unemployment rate at 4.0 percent, a tick below the Fed’s estimate of full employment, but the Fed’s efforts to lower inflation to its target have stalled. Consumer Price Index (CPI) inflation is 3.0 percent and the Fed’s preferred measure, Personal Consumption Expenditures or PCE inflation, is 2.6 percent. Consumers are reeling from prices 23 percent higher than before the COVID pandemic.
The Fed’s task of achieving its dual mandate is difficult under any circumstances, and tariffs that bump up prices, weaken economic data, and add uncertainties make the Fed’s task more challenging. Key measures of inflationary expectations have risen in response to the latest inflation data and low unemployment rate. Market-based measures of inflation expectations in the next five years have risen to 2.6 percent, while the University of Michigan survey of inflationary expectations has jumped to 4.3 percent in the next year and 3.3 percent in the next five years.
Amid these pressures, the Fed must continue to pursue a monetary policy that is consistent with moderating nominal aggregate demand that achieves lower inflation and anchors inflationary expectations to 2 percent. Even a tariff-induced one-month bounce in the inflation measures could trigger a further rise in inflationary expectations that risks inflationary wage-price catch ups. Dealing with heightened uncertainties stemming from Trump’s tariffs and related meddling in international trade places extra burdens on the Fed.
President Trump’s aggressive tilt toward central control of the government’s functions and practices could also involve attempts to achieve some desired level of the US dollar. This may involve efforts to influence the Fed’s monetary policy or to order the Treasury along with the Fed to intervene in foreign-exchange markets. The current strength of the US dollar reflects the high risk-adjusted expected rates of return on dollar-denominated assets associated with the relative outperformance of the US economy compared to other nations, and expectations that its potential growth is higher. These favorable foundations are also reflected in the higher real interest rates in the US than abroad. Attempts to manage either interest rates or the currency would have negative repercussions. Trump publicly criticized the Fed’s monetary policy during his first term and has argued that he should have some say over interest rates. This, of course, would be a big mistake. The benefits of an independent central bank that pursues low inflation as the best foundation for healthy growth of the economy and employment are well known.
Any outside pressures on the Fed to alter monetary policy could pose an uncomfortable situation for the Fed. Fed Chair Jay Powell has properly emphasized that the Fed will remain independent in its conduct of monetary policy and would push back on any outside influences. If Trump pressures the Fed, it should not fight this battle alone: Congress must give the Fed its full support. The Fed is chartered by Congress, which oversees and supervises it through the Senate Banking Committee and House Financial Services Committee. Committee members on both sides of the aisle must back the Fed on this critical issue.
The Treasury may order the Fed to intervene in foreign-exchange markets, and by law the Fed must comply. Achieving a desired US dollar value through foreign-exchange intervention changes the magnitude of reserves in the banking system and the Fed’s base money, which may steer monetary policy off course. The Fed may “sterilize” its foreign-exchange operations by offsetting them with domestic operations; such sterilization has been shown to neutralize the impact on currencies and leave monetary policy unchanged. But it adds unnecessarily to market volatility and undermines the Fed’s credibility in its pursuit of price stability.
The Treasury, along with the Fed, frequently intervened in foreign-exchange markets in the high inflation period from the mid-1960s and 1970s as it tried to deter capital outflows (and gold sales leading up to the closing of the gold window in 1971). In the 1980s, the Treasury coordinated with foreign governments to achieve desired exchange rates (the Plaza Accord in September 1985 and the Louvre Accord in 1987). Frequent interventions continued through the 1990s. None of these interventions had much of an impact.
In recent years, interventions have been rare. However, the Trade Facilitation and Enforcement Act of 2015 mandated the Treasury to closely monitor and report on nations that have large bilateral trade and current-account deficits with the United States and their foreign-exchange interventions. This makes today’s situation, with an activist president misinterpreting the trade and current-account imbalances, particularly fraught with pressures to resume intervention activity.
Holding the line
In sum, President Trump has imposed tariffs in the face of overwhelming economic research that indicates they will harm economic performance—as well as ignoring historical evidence, including from during his first term, that they will fail to achieve desired objectives. We worry that Trump’s nationalism and preference for lower interest rates and a lower US dollar may lead him to pressure the Fed or even order intervention into foreign-exchange markets. If taken, these steps must be rebuffed, with Congress supporting the Fed’s independence to pursue price stability and its dual mandate.
