U.S. Tariffs – How Wrenching for the Global Economy?

In a new Citi Research note, a team led by Chief Economist Nathan Sheets explores key issues related to the White House’s raising of U.S. tariffs to historically high levels and the implications for U.S. and global economies through the year ahead. 

Since President Trump took office, the overall U.S. effective tariff rate has risen from roughly 2.5% to well over 20%. With further sectoral tariffs likely in the weeks ahead, we expect the tariff rate will likely peak at 25% or even higher. These are the highest tariffs faced by the U.S. economy since the early 1900s, larger even than the Smoot–Hawley tariffs of 1930. But they come at a time when the global economy is much more deeply integrated.

There are few precedents to draw on in judging the likely effects of such policies. At best, they represent an ambitious effort to bring the U.S. increased benefits from its role as the world’s largest and most influential economy. But they also seem to threaten a range of unattractive lose-lose outcomes.

Implications for growth and inflation

One of our key findings is that the tariffs are a stagflationary shock for the U.S. They push up import prices and then pass through into higher prices for consumer goods and higher inflation. The tariffs act as a tax on spending, creating a corresponding drag on growth. For the rest of the world, tariffs are an adverse demand shock. They reduce demand for foreign products in the U.S., which puts downward pressure on both prices and real gross domestic product (GDP) abroad. Should other countries aggressively retaliate, the script is flipped, with a supply shock imposed on those countries’ economies and the U.S. experiencing a demand shock.

We estimate that the tariffs could push up U.S. consumer price inflation by 1–2 percentage points (pp) over the next four quarters. Downward pressures on spending would be of similar magnitude, with U.S. growth roughly 2 pp lower over the next four quarters or so. We do note, however, that other estimates of the GDP effects yield assessments closer to 1 pp.

We see a distinct risk that inflation could rise as high as 4% as the tariffs’ effects work their way through the economy. In tandem, we see plausible scenarios in which growth falls well below 1% and perhaps to zero. Even if the ultimate effects are less pronounced, this would create a challenging situation for Chair Powell and the Fed.

For the rest of the world, our work suggests tariffs could push growth as much as 1 pp lower over the next four or five quarters. This would put global growth somewhere around 2%, down from nearly 3% in each of the last two years.

Potential mitigating factors for the U.S. economy

While tariffs will put upward pressure on U.S. prices and downward pressure on private spending, they are also likely to generate significant revenue for the U.S. government.
A straight read-through of the tariffs suggests revenues could rise by $700 billion to $750 billion a year. But we suspect there’s likely to be significant slippage “from cup to lip.” Such slippages include: 

• “layovers” in which exports from high-tariff jurisdictions go to low-tariff ones;
• shifts in U.S. spending patterns to lower-tariff goods and toward services;
• some production and sourcing moving to the U.S.;
• increased government expenses needed for tariff implementation and enforcement; and
• lower tax revenues due to the restraint on real GDP growth. 

The bottom line? We think net new annual revenues would likely be in the neighborhood of $500 billion, or 1.7% of GDP.

A corresponding question is what the Trump administration would do with these revenues. Tax cuts are an option, and returning revenues to the income stream through tax cuts would offset the downward pressure on GDP. But this would also reinforce and exacerbate tariffs’ inflation effects, countering an adverse supply shock with a positive demand shock.

We add a caveat: The effects of the tariffs should largely come online over the next four quarters, i.e. through the first quarter of 2026. But the effects of tax cuts may not be felt until much later this year or early in 2026, meaning the support to growth from tax cuts could meaningfully lag the downdrafts from tariffs.

Another option would be to use these revenues to reduce the U.S. fiscal deficit. With the extension of President Trump’s 2017 tax cuts, we estimate deficits are likely to run in the ballpark of 6%–7% of GDP through the coming decade; tariff revenues could represent a significant down payment on deficit reduction. Markets would likely welcome such an action, which could be helpful in driving down longer-term Treasury yields. 

President Trump’s deregulation agenda is another important initiative that will likely provide support for the U.S. economy and help mitigate the drag from tariffs. We continue to expect a less restrictive regulatory stance for a range of sectors including energy, finance and healthcare, likely complemented by lighter-touch policies related to climate, labor relations and consumer protection. In the near term, deregulation is likely to bring increased output and help lower the costs of production, adding up to a positive supply shock for the economy. It’s reasonable to expect that tax cuts and deregulation together could lift U.S. GDP by roughly 0.5 pp and offset some of the drag from tariffs.

We also note that in recent years the U.S. economy has shown notable resilience, with growth remaining near 3% and defying expectations that Fed rate hikes would push it into negative territory. The true upside scenario is that this resilience continues in the face of the tariffs, with pain spread in so many directions that no particular sector is unduly depressed. But this story could have been told more convincingly for a 10% tariff hike; with the actual increase much larger, there is a lot of pain that must be borne.

Implications for central banks

Central banks’ response will be a pivotal part of the story, but we note that as the central bank of the country imposing the tariffs, the Fed faces a thorny policy challenge, one that’s fundamentally different from those faced by central banks seeking to manage adverse demand shocks.

For the Fed, the upfront policy prescription is “wait and see.” The key question is which will dominate through the coming year: the negative GDP effects or the upside pressures on prices? Chair Powell recently noted that the Fed is currently in a good place: its policy stance is moderately restrictive, leaving the Fed well positioned should it need to counter inflation pressures, and it has significant dry powder to deploy should the economy weaken appreciably.

In assessing inflation risks, the Fed will focus on several questions, including if longer-term inflation expectations are still well anchored and if tariff-related inflation is starting to bleed from goods into services inflation. With inflation still above target, we expect the Fed to take pains to protect its inflation-fighting credibility.

On the growth side of its mandate, the Fed will be closely watching the labor market, though the inflation challenges create a high bar for cutting rates to provide support. The Fed would respond if the labor market started to crack, but that might require a couple of months of negative payroll prints alongside a rapid rise in the unemployment rate.

Given the surprisingly large size of the U.S. tariffs, we see both the inflation risks and the growth risks facing the economy as first-order. For now, we lean more toward concerns about growth, noting the possibility that rising economic uncertainty could trigger a pause in spending and slower growth as households and firms also “wait and see.”

The implications for monetary policy in the rest of the world look less complex. Countries are likely to face weaker export growth, which should put downward pressure on both their real GDP and inflation. The clear policy prescription in response is to cut rates more aggressively than had been envisioned; central-bank policy tools are well designed to manage demand shocks.

To that we add an important caveat, however: The tariffs could bring appreciable downward pressures on exchange rates vs. the dollar. Developed-markets economies would generally be comfortable absorbing this, but some emerging-markets economies could fear the resulting pass-through to inflation or currency instabilities, possibly constraining their scope to cut rates.

The bottom line is that central banks must be vigilant and prepared to act aggressively through this period of amplified economic uncertainty.

Four open questions

In analyzing U.S. tariff policies, four open questions stand out to us:

1. To what extent does the rest of the world retaliate? We anticipate responses from some countries but expect they’ll be far less than one-for-one, with most countries hesitant to put comparable tariffs on their own consumers and fearing escalation from the U.S.
2. How willing is President Trump to negotiate, and how quickly? While the president is clearly committed to his tariff agenda, he is also a dealmaker at heart, and has signaled willingness to engage in discussions.
3. How much economic and political pain is the White House willing to absorb? The baseline scenario we’ve described entails a significant disruption in U.S. economic activity, and tariffs have jolted markets. And unlike other recent major shocks, this episode has been entirely induced by Presidents Trump’s policy choices.
4. What is the eventual configuration of tariffs on Mexico and Canada? Those two countries represent nearly 30% of U.S. goods imports, making the landing zone with these economies important. Where these tariffs ultimately land will shed important light on the White House’s broader tariff strategy.