The Downside Risks of Reciprocal Tariffs

Our Global Chief Economist Seth Carpenter explains the potential domino effect that President Trump’s reciprocal tariffs could have on the U.S. and global economies.

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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist, and today I'm going to talk about downside risks to the U.S. economy, especially from tariffs.

It's Thursday, February 20th at 10am in New York.

Once again, tariffs are dominating headlines. The prospect of reciprocal tariffs is yet one more risk to our baseline forecast for the year. We have consistently said that the inflationary risk of tariffs gets its due attention in markets but the adverse growth implications that's an underappreciated risk.

But we, like many other forecasters, were surprised to the upside in 2023 and 2024. So maybe we should ask, are there some upside risks that we're missing?

The obvious upside risk to growth is a gain in productivity, and frequent readers of Morgan Stanley Research will know that we are bullish on AI. Indeed, the level of productivity is higher now than it was pre-COVID, and there is some tentative estimate that could point to faster growth for productivity as well.

Of course, a cyclically tight labor market probably contributes and there could be some measurement error. But gains from AI do appear to be happening faster than in prior tech cycles. So, we can't rule very much out. In our year ahead outlook, we penciled in about a-tenth percentage point of extra productivity growth this year from AI. And there is also a bit of a boost to GDP from AI CapEx spending.

Other upside risks, though, they're less clear. We don't have any boost in our GDP forecast from deregulation. And that view, I will say, is contrary to a lot of views in the market. Deregulation will likely boost profits for some sectors but probably will do very little to boost overall growth. Put differently, it helps the bottom line far more than it helps the top line. A notable exception here is probably the energy sector, especially natural gas.

Our baseline view on tariffs has been that tariffs on China will ramp up substantially over the year, while other tariffs will either not happen or be fleeting, being part of, say, broader negotiations. The news flow so far this year can't reject that baseline, but recently the discussion of broad reciprocal tariffs means that the risk is clearly rising.

But even in our baseline, we think the growth effects are underestimated. Somewhere in the neighborhood of two-thirds of imports from China are capital goods or inputs into U.S. manufacturing. The tariffs imposed before on China led to a sharp deterioration in industrial production. That slump went through the second half of 2018 and into and all the way through 2019 as a drag on the broader economy. Just as important, there was not a subsequent resurgence in industrial output.

Part of the undergraduate textbook argument for tariffs is to have more produced at home. That channel works in a two-economy model. But it doesn't work in the real world.

Now, the prospect of reciprocal tariffs broadens this downside risk. Free trade has divided production functions around the world, but it's also driven large trade imbalances, and it is precisely these imbalances that are at the center of the new administration's focus on tariffs. China, Canada, Mexico – they do stand out because of their imbalances in terms of trade with the U.S., but the underlying driving force is quite varied. More importantly, those imbalances were built over decades, so undoing them quickly is going to be disruptive, at least in the short run.

The prospect of reciprocity globally forces us as well to widen the lens. The risks aren't just for the U.S., but around the world. For Latin America and Asia in particular, key economies have higher tariff supply to U.S. goods than vice versa.

So, we can't ignore the potential global effects of a reciprocal tariff.

Ultimately, though, we are retaining our baseline view that only tariffs on China will prove to be durable and that the delayed implementation we've seen so far is consistent with that view. Nevertheless, the broad risks are clear.

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