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.
----- Transcript -----
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.
Thanks for listening. And if you enjoy the show, please leave us
a review wherever you listen and share Thoughts on the Market
with a friend or colleague today.
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