TD Economics: Rising trade tensions with China to weigh on growth, spur inflation

By Beata Caranci
Senior Vice President and Chief Economist

United States tariffs have been an ongoing theme since the March announcement on steel and aluminum.

While these tariffs were broadly applied and affected most countries, including U.S. traditional allies and NAFTA partners, tariffs announced since then have largely been targeted against China. The first tranche of U.S. tariffs focused on roughly US$50-billion in “technology” imports, or products included as intermediate or capital goods. These ultimately raise costs for U.S. businesses, but the relatively small share of targeted products constrained that scope.

On September 24, phase 2 now ramps up the pressure on businesses to constrain costs, with US$200-billion in Chinese imports incurring 10% tariffs until year-end, rising to 25% thereafter. There’s also the potential for Phase 3 to occur, representing an additional 10-25% tariff on US$267-billion in Chinese imports. This increasingly targets consumer goods, which will directly raise prices for American consumers, in addition to the ongoing potential for higher business input costs to be passed on to consumers.

China has not sat idle, choosing to retaliate in a strategic fashion. China’s Phase 1 response focused import tariffs on cars, as well as agricultural products like soybeans and pork. These are goods often produced within states where constituents tend to vote conservative. Phase 2 retaliation amounting to 5-10% tariffs on US$60-billion in U.S. products has shifted to include intermediate inputs and capital equipment. Beijing likely recognizes the costs to Chinese companies of raising the price of key components, and is keeping some tariffs as low as 5% on certain goods.

The latest tit-for-tat trade spat is likely to have negative economic repercussions for both the U.S. and Chinese economies. Model simulations suggest that a 10-25% tariff on US$200-billion in Chinese goods import could hit U.S. GDP growth by between 0.1 and 0.4 ppts in a little over a year’s time, depending on whether the U.S. administration follows through on applying the 25% tariff in the New Year.

Implicit in this estimate is an assumption that sentiment among consumers and businesses is impacted, accounting for a third of the drag on U.S. economic growth. If these impacts fail to materialize, the drag to economic growth falls to the lower end of the range. However, we think it’s a leap of faith to assume equity markets would not recalibrate to lower earnings growth potential.

Furthermore, it must be said that these estimates are calibrated on historical relationships and are designed to approximate the reality of the international trade order. The effect on domestic income and consumer purchasing power is highly uncertain, as is the ability of firms to substitute away from more expensive imports to domestically produced goods.

Nevertheless, these impacts don’t affect the end result of tariffs leading to less efficient supply chains, and by extension, higher production costs and less competitive domestic firms.

Since China has retaliated by imposing 5-10% tariffs on US$60-billion of U.S. goods, there is an ever-present risk that the U.S. follows through on its threat to up-the ante with an additional 10-25% tariff on the remaining US$267bn in Chinese goods imports. This move could endanger an additional 0.4 ppts of U.S. GDP growth. Adding it all up, further escalation could reduce U.S. economic growth by up to 0.8ppts over the eighteen months or so, and is consistent with a loss of between 250k to 560k jobs relative to our baseline forecast (+0.15 to +0.34 ppt increase in the civilian unemployment rate, depending on the total amount of goods targeted by tariffs).

Since more consumer goods were included in the current round of tariffs higher consumer prices are all but guaranteed. Model simulations suggest a peak impact on inflation a year from now of about +0.1 to +0.3 ppts in the case of U.S. tariffs of 10-25% on US$200-billion, and an additional +0.6 ppts if the U.S. were to impose a 25% tariff on an additional US$267-billion in Chinese goods imports.

The potential impacts of the tariffs already in place may not sound notable in an economy trending close to 3% growth. But, due to waning fiscal impulse and tighter financial conditions our recent forecast has growth slowing towards 2% by early 2020 – when the peak impact from the tariffs would occur. In that scenario growth would slow below 2%, and the economy would look much more anemic than the growth impact implies at first glance.

Tit for Tat or Cold Trade War?

The U.S. market for imported goods is US$2.4-trillion, and home to some of the world’s wealthiest consumers. This gives the U.S. much of the leverage in trade negotiations with other nations. Chinese imports of US$505-billion comprised about one-fifth of total U.S. imports in 2017, representing a mix of intermediate and finished goods. Therefore, tariffs do not just make imported goods more costly for consumers, but also raise costs for U.S. industries that rely on global supply chains, threatening to make them less competitive overall.

Chinese authorities recognize that the U.S. has the upper-hand in negotiations, and have been careful in their response in order to mitigate any potential damage to their economy. In response to U.S. tariffs on Chinese goods this year, China has levied tariffs on about US$113-billion (or 86% of the total).

China was open to ongoing dialogue with the U.S. administration, but has openly stated they would not negotiate under threat, but still remain amenable to talks in late October or a November trade summit. So it was not altogether surprising that China pulled out of scheduled talks once the U.S. announced they would proceed with the tariffs targeting US$200-billion Chinese products.

So there we have it. Both countries have moved closer to intractable positions. This was reinforced by China earlier this week when they published a whitepaper stating its position on trade with the U.S. This document highlights mutually beneficial aspects of China-U.S. trade cooperation, but also addresses that the ‘America First’ attitude of the new U.S. administration has “abandoned the fundamental norms of mutual respect and equal constitution that guide international relations.” Moreover, the document highlights the importance of China and U.S. in the global economy, and that current trade tensions threaten to slow global growth.

Global growth implications

Certainly, further escalation may start to impair global supply chains, risking a slowdown in global trade, investment, and ultimately economic growth. A slowdown in Chinese economic growth from the current 6.6% pace may put in peril the growth outlook in its East Asian trading partners that together comprise about 10% of global economic activity.

However, the China trade spat may provide opportunities for these same trade partners to gain more Chinese business at the expense of U.S. firms. Nevertheless, since much of the value added in Chinese exports is generated abroad, these tariffs may exacerbate the economic slowdown already underway in China that has been orchestrated by authorities to wean the economy off its overreliance on debt. As such, supply chain partners outside of Asia, such as Europe, are also likely to be negatively impacted. For example, we estimate that a 1% decline in Chinese output would result in up 0.2% loss in European output, and this could compound the drag on U.S. output from tariffs (Chart 5).

Although there remains hope that dialogue will provide a resolution to the current tit for tat trade dispute, there is reason to be worried that this is the first battle in a long cold trade war with China. It’s difficult to see how a new trade deal or global trade paradigm will satisfy both the U.S. demand for fairer trade, and China’s longer-run ambition of becoming a global economic and military power in the next few decades. This means that trade frictions between the two economic powers are likely to escalate in coming months, and that the thicker borders between the two nations may provide a significant headwind to global growth beyond the estimated 0.3ppt drag.

Beata Caranci

Senior Vice President and Chief Economist

TD Bank Group