The economic impact of US tariffs
By the OFX team | 11 February 2025 | 5 minute read
As US President Donald Trump follows through on his campaign pledge to apply tariffs on China, Canada and Mexico, threatening the same against the European Union, it seems the USA’s role as champion of global integration and free trade is all but forgotten.
The purpose of this rhetoric and executive orders is unclear. It is not solely an economic issue; the White House says the “bold action” of the initially announced tariffs is to hold Mexico, Canada, and China accountable to their promises of halting illegal immigration and stopping the flow of fentanyl and other drugs into the US.
Early in February, President Trump imposed a 25% tariff on most Mexican and Canadian imports and a 10% tariff on Chinese imports. Mexico, Canada and China account for more than 40% of total goods traded with the United States.
Only three days later, the introduction of the tariffs on Canada and Mexico was postponed for one month. All three countries declared retaliatory tariffs, sparking fears of a trade war.
In his first administration, Trump imposed tariffs on Chinese goods – China then imposed retaliatory tariffs – which left 60% of US-China trade subject to 20% tariffs. It was, “the largest and most sustained return to protectionism since the 1930s”.1 Said Pablo D. Fajgelbaum, Professor of Economics at the University of California-Los Angeles (UCLA) in a May 2021 paper.
More importantly. It didn’t materially work. Professor Fajgelbaum’s analysis showed that while total imports fell, import prices (before tariffs) did not fall, and with tariffs included, import prices increased one-to-one with tariffs. In other words, the tariffs were passed-on to consumers. While trade relations stabilised, the cost to US consumers was 0.6% of GDP. Politically, while there was higher import protection provided to electorally competitive counties, Professor Fajgelbaum found that counties with predominantly Republican votes were most negatively affected due to retaliation.
Trump’s tariff announcement caused accentuated volatility across markets. The US Dollar Index (DXY) jumped 1.3% on the announcement of the US tariffs, and then fell 2.1% on the comeback punch of the victims. But there are bigger influences at play in the foreign exchange (FX) markets.
First, there is the constant interplay of risk-on, risk-off sentiment with the latter boosting the US dollar, which (like gold) has come to be viewed as a ‘safe haven.’ In this context, growing global uncertainty about a trade war leads people to park funds in the greenback.
Then there is the interest-rate driver of currency trades. If traders perceive that the US Federal Reserve (Fed) is likely to cut interest rates, that potentially weakens the US dollar. This, of course, was the situation that prevailed before the tariff announcements. In that context, the greenback always has US economic data to contend with.
Since the tariffs’ announcement, the US Bureau of Labor Statistics has reported the latest Job Openings and Labor Turnover Survey (JOLTS), which showed that job openings fell to 7.6 million in December from 8.1 million in November; 8 million short of the market expectations. That release took about 0.4% from the US Dollar Index, because weaker job openings numbers imply more supportive Fed policy.
At the time of writing, the markets awaited the latest US initial jobless claims data, and the (more important) non-farm payrolls figure for January. As a precursor, the private ADP Research Institute Employment Change data3 showed that employment at US companies picked up in January by more than forecast, highlighting resilient job growth, despite mounting uncertainty. The jobs report typically sets off major moves across various markets, particularly if the figures are significantly different to the widely publicised consensus expectations of market economists. A stronger-than-expected report would likely boost the US dollar, as it would broadly reduce expectations for interest rate cuts from the Fed.
Inflation readings also have a significant influence on the FX market. Tariffs effectively act as a tax on imported goods, pushing prices higher in the destination country, potentially pushing inflation higher: that would be very influential on the policymakers at the Fed. Higher inflation expectations in the US could force the Fed to keep elevated interest rates steady, providing support for the US dollar.
Confused? Join the crowd. And that confusion, in itself, is potentially a suction force into the US dollar, as a safe haven — which is even more confusing.
As always, currencies are traded in pairs (you are selling one to buy the other, and vice versa), and often one side of that trade is the bigger driver.
Similarly, Trump threatened the Europe Union with tariffs, causing the euro to be heavily sold against the dollar in the first week of February, from US$1.04 to US$1.02, before regaining all that ground and more, to US$1.04248; only to start sliding again when the January ADP Employment Change figure came in upbeat, ahead of the January jobs report. That’s great volatility for traders, but confusing in the longer-term outlook.
Currency markets are guessing just as much as anybody. If Trump’s tariffs successfully reduce imports, the US trade deficit could narrow, potentially contributing to dollar strength. But if trade restrictions crimp US economic growth significantly, the Fed might need to cut rates, weakening the dollar.
And currency movements can change the effects of tariffs. Last time around, the Chinese yuan depreciated, reducing the price of Chinese goods in US dollars. That was one of the factors, along with the Chinese government subsidising some factories, helping them to offset the tariff impact, that made economic tariff theory a very imperfect guide to what would happen in the real world. As it will be this time around.
But in a more volatile market, the attributes of the greenback give it a bullish sheen.