How to deal with Trump’s tariff threats

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For Donald Trump to announce tariffs and extort trading partners weeks before entering office is true to form. His choice of victim was always going to have a random element.

Canada was hit despite aligning with US trade over the years, including putting tariffs on Chinese electric vehicles. Mexico has had a more fractious relationship with the US but the trilateral US-Mexico-Canada trade deal has held together. China may be the known adversary but local stock markets shrugged off Trump’s late-night social media post; investors had expected a higher tariff rise than the 10 per cent Beijing was threatened with.

But given that Trump’s tariff policy is trying to hit several entirely contradictory goals, immigration and the drugs trade were, frankly, as likely a target as any other. For the US president-elect, tariffs aren’t just trade policy as such. They are also a form of geopolitical leverage.

The exact instrument he will use to raise tariffs remains unclear, though to do so on inauguration day on January 20 will probably require the International Emergency Economic Powers Act, which, as its name suggests, involves declaring a national state of emergency. Richard Nixon used IEEPA’s precursor legislation, the Trading with the Enemy Act, to impose an across-the-board 10 per cent tariff on imports in 1971 amid the collapse of the Bretton Woods fixed exchange rate system.

Analysing high-frequency market reactions can be highly misleading as a guide to the medium-term direction of policy: Trump might reverse course tomorrow. Yet it is notable that traders’ instinct was to buy rather than sell the dollar. In itself, this is not a shock: theory and (often) practice show that tariffs tend to appreciate the exchange rate.

However, this will work against one of Trump’s other professed goals for tariffs: to close the overall US deficit. After he announced at the weekend that hedge fund manager Scott Bessent was to be nominated as Treasury secretary, the dollar softened somewhat — perhaps in the expectation that by attacking the independence of the Federal Reserve, as Bessent has suggested, his nomination meant that interest rates would be lower than expected.

As we learned from his first term, where heavy import taxes being levied on imports from China merely meant that goods were routed via countries such as Vietnam, or indeed Mexico, selective tariffs tend to rearrange production and trade networks rather than repatriate production. Although Canada and Mexico run a trade surplus with the US in contrast to the likes of China, they run overall trade deficits against all trading partners. Further reducing their overall exports, if that is the effect of tariffs, will not reduce global imbalances.

In practical terms, what do the Canada and Mexico tariffs mean? If Trump means it to apply to oil and gas, it could have a rapid effect on US consumer prices — exactly the opposite of what he promised in the election campaign. Although the US has become a net oil exporter, in 2022 it still imported 8.3mn barrels a day of petroleum products out of a total consumption of 20.3mn b/d, of which about 70 per cent came from Canada and Mexico. More than a third of Canada’s total exports to the US are hydrocarbons. It is not costless to switch between domestic production and imports.

Otherwise, both countries are heavily integrated into supply chains, particularly in cars, a pattern Trump’s first-term renegotiation of the trilateral Nafta trade deal into the US-Mexico-Canada agreement did not much change. As of 2022, almost a third of Mexico’s $70bn in motor vehicle exports to the US — Mexico and Canada make up more than a third of total US auto imports — were in parts and components. A tariff crunch could pose the threat of creating chokepoints in a production network as an important input suddenly jumps in price.

What are Canada, Mexico and China’s options, and indeed those of other trading partners such as the EU that are bracing themselves for similar coercion? The most immediate one is vaguely promising to do something about immigration and fentanyl and hoping this allows Trump to present his gambit as a success, even before he takes over from Joe Biden.

One of the most successful Trump-management episodes in his first term was European Commission president Jean-Claude Juncker promising that the EU would buy soyabeans and liquefied natural gas in return for Trump holding off on car tariffs. The pledges were meaningless — the commission president has no such powers — but Trump could call it a victory.

Another strategy for trading partners would be to see if the countervailing forces within the US system manage to assert themselves. During his first administration, Trump was on the verge of pulling out of Nafta altogether before he was persuaded by his agriculture secretary, Sonny Perdue, and commerce secretary, Wilbur Ross, that it would hurt farmers and border states. Instead, he settled for the fairly modest renegotiation. Any suspicion of a sudden leap in petrol prices, or a more serious stock market sell-off, might persuade him.

In the meantime, the best option for the three countries targeted by Trump might be simply to wait and see what the impact of the tariffs will actually be. Economic modelling during the first Trump administration suggested that retaliation by Canada to his tariffs might make the damage to the Canadian economy worse. Companies have done extraordinary things in recent decades managing to keep supply chains going around restrictions. It would be premature to rule out their ability to cope with these tariffs as well.

Data visualisation by Amy Borrett and Ray Douglas in London