April 8, 2025

It's been four full trading days since the announcement of global "reciprocal" tariffs by the United States--which are meant to go into effect tomorrow. Here are a few things we've learnt over the period:

A. The Tariff Fiasco

1. The tariff rollout was meant to be Trump's crowning achievement--he termed it "Liberation Day" and spoke from the Rose Garden. Instead, it has turned into a full-blown policy fiasco.

2. To begin with, the tariff policy has been revealed to be both flawed economics and flawed arithmetic. Flawed economics because even a mercantilist has no reason to argue for zero bilateral trade deficits with every country. Even if the policy were to achieve this outcome, it would be a deeply suboptimal outcome for the U.S. economy. 
3. Flawed arithmetic because, in calculating the tariffs, the administration simply picked the wrong variables. No one can put it better than our very own Senior Advisor Stan Veuger and his co-author Kevin Corinth did for AEI: " It is inconsistent to multiply the elasticity of import demand with respect to import prices by the elasticity of retail prices with respect to tariffs."
4. Why does this matter for markets? Because it shows that the defining characteristic of economic policymaking at this administration is not nationalism or a fondness for manufacturing: it is incompetence. 
5. This incompetence led to the policy error announced at the Rose Garden last week. It led most Wall Steet economists to up their recession estimates, crushed stock market valuations, and, despite all this, still managed to leave us with a higher 10Y (at 4.3% as I write this).
6. The steepness is even more impressive--2Y10Y is at 56bps. The 30-year has rallied 40bps since Friday at the same time as the SP 500 (and most global equity indices) have been tanking.
7. There are concomitant arbitrage unwinding considerations here--but this is not a good reason to disregard the price signal.
8. Needless to say, this is not good news. The policy error is so grave that it has managed to deliver a blow to U.S. economic conditions, U.S. fiscal credibility, and the dollar's reserve status in one fell swoop. 

B. The Fiasco Playbook

1. How does this play out from here? The good news is that policy fiascos tend to self-correct politically. In other words, the actor driving the policy change bumps against institutional or political constraints. 
2. This is why, for example, in the UK crisis of 2022, Liz Truss first reversed her policies and was then forced out, which put a lid on gilt yields (though it did leave the UK borrowing with a "moron premium" for quite some time). 
3. Though Donald Trump is not going anywhere, the policy will likely be moderated via international "dealmaking." The upside of attempting to destroy international trade via executive action is that some tariffs can be reversed fairly quickly, for whichever reason or no reason at all.
4. This is likely to happen because the political constraints are becoming apparent. One of the many flaws of launching a trade war against everyone at the same time (rather than, say, one aimed at China) is that it is easier for people to focus on the real target of the mercantilist policy: the American consumer. 
5. The Republican Party is realizing that its president is on course to cause massive economic damage to the country--and they are likely to own the result. This is what Ted Cruz (R-TX) meant when he warned the Republicans are facing an electoral "bloodbath" in 2026 if the policy goes ahead.
6. The seven Republican senators who signed up for a bill to control the president's tariff authority are also likely to push the administration into a more conciliatory stance. 
7. While it is unlikely that the bill will amass a veto-proof majority in both houses any time soon, it is likely to remind Trump that his power is not unlimited. 
8. These divisions are also obvious within the Cabinet, or at least among the Cabinet's observers. Earlier today, Elon Musk called Trump's trade adviser Peter Navarro "truly a moron." 
9. Finally, markets are very eager to see a reversal, as evidenced by the SP 500 moving up by 400 points in the space of 30 minutes--on a fake news report that the administration was considering a 90-day pause. 
10. So, in the short run, we would expect some policy reversal in the form of trade "deals" with allied countries, such as Japan, South Korea, and the European Union. But as Monday proved, any rally can sour quickly and investors should not mistake policy reversal for a change of heart.

C. Wrong Idea, Poorly Executed

1. While we expect the short-term damage to be contained, it is important that investors do not delude themselves into thinking the administration will learn from this mistake. 
2. Instead, we recommend thinking about the next shoe to drop. In terms of international actors, this could be targeting services exports, where the U.S. excels--and which the administration omitted from its "calculations." Both the EU and China have given hints to that effect. 
3. From the U.S. side, it could come in terms of targeting capital flows--a point we have stressed before and would stress again.  
4. Reading recommendation: CEA Chair Stephen Miran gave a speech at the Hudson Institute on Monday, in which he outlined his ideas on America's provision of "global public goods" i.e. the U.S. dollar. 
5. The speech has many flaws, but this is beside the point. The critical point is that the administration has the reserve currency in its sights--and consistently fails to see the immense benefits (the "exorbitant privilege," as d'Estaing called it) that accrue to the United States. 
6. The good news? Regardless of whether foreigners retaliate or cooperate, this should be bearish for the dollar in aggregate.

D. Some Fed Thoughts

1. I continue to find it extraordinarily difficult to see the Fed cutting as inflation expectations (very reasonably) march upwards. 
2. Combining this with the very strong jobs report we got last Friday, current market probabilities (60% cut in May) seem like wishful thinking. 
3. My reasoning here is as follows: the Fed has failed to hit its target for five Decembers in a row. It was highly unlikely, even by its own estimates, to hit it this year. And it is even more unlikely that it will do so as these tariffs go into effect. 
4. A rate cut here, even if a recession is imminent (which is not my or the Fed's base case), would send a clear signal to businesses and consumers that the Fed does not care about inflation--and that they should proceed to raise their inflation expectations. 
5. This is precisely what happened in the late 1960s and most of the 1970s. It is well documented in the literature and Jay Powell has (if belatedly) read up on it. 
6. To some extent, the genie has already left the bottle. Throughout the past three quarters, the Fed has been very weak in pushing back against inflation, which is why survey-based expectations are in deeply uncomfortable levels--and why it is likely break-evens will be next. 
7. A rate cut now would only add fuel to the fire--making the short duration trade even more appealing.

All best,

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