A Move Away From Free Trade

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Now comes the big test for the economy: Can it withstand the costs of new tariffs while awaiting potential benefits later, without slipping into recession? President Donald Trump is betting that it can. Businesses and investors aren’t so sure.

While Trump is levying tariffs selectively — enacting some, threatening more, holding off on still others as a bargaining move on other issues — a move away from free trade is clearly here. Businesses, consumers and investors need to adapt to an environment in which many imports cost more, some supply chains get scrambled, and U.S. exports become less competitive due to retaliatory tariffs. Hence, the recent sell-off on Wall Street, as concerns about tariffs hurting corporate earnings combine with broader concerns about the economy.

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Short-term pain, long-term gain?
For now, Trump isn’t budging. He thinks that some short-term pain is worth the long-term gain of bringing more manufacturing back to America. He may be right. Some firms are announcing that they will start making, or make more, products in the U.S. Among them are Hyundai, Honda, Volkswagen, Volvo, server maker Inventec, luxury-brand owner LVHM, Compal Electronics and Campari, the spirits maker. But forcing a major rebound in U.S. manufacturing is a long-term endeavor. Tariffs need to be both painful and long-lasting to justify investing in plants here.

Meanwhile, the costs of new tariffs arrive quickly. Consumers pay more as importers pass along part of the tariff cost. Manufacturers that rely on imports of materials or components see their costs rise, or worse, slow down production if certain goods are no longer economical to import. Higher costs risk fueling inflation. These concerns are likely behind the recent deterioration in consumer sentiment.

Shallow recession could hit this year
Our take: GDP growth is going to take a hit, and recession risk has risen. The economy still has key sources of strength. The unemployment rate remains low, even with recent government layoffs. As long as employment holds up, consumers will too, even if it strains their finances somewhat. So for now, outright recession doesn’t seem imminent. But a shallow one could hit later in the year as tariffs bite. If businesses slow investments and hiring due to confusing trade policy and consumers rein in spending due to worries about their jobs, the economy can’t help but suffer.

All this puts the Federal Reserve in a bind. If GDP is slowing but inflation is rising, the Fed has to choose which problem to address and which to let worsen. Since tariffs generally lead to one-time price increases, the central bank is likely to downplay the inflation risks, at least initially. But if tariffs lead consumers to think that more price increases are coming, that mindset can become self-perpetuating. That may tie the Fed’s hands on interest rate cuts just when the economy needs them.

This forecast first appeared in The Kiplinger Letter, which has been running since 1923 and is a collection of concise weekly forecasts on business and economic trends, as well as what to expect from Washington, to help you understand what’s coming up to make the most of your investments and your money. Subscribe to The Kiplinger Letter.

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