Tariffs’ Impact on Economy and Bond Markets

Summary

Summary of "Tariffs’ Impact on Economy and Bond Markets"

Podcast: Thoughts on the Market
Host/Author: Morgan Stanley
Episode Title: Tariffs’ Impact on Economy and Bond Markets
Release Date: August 13, 2025

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Introduction

In the August 13, 2025 episode of Thoughts on the Market, Morgan Stanley's Michael Zezas and Chief U.S. Economist Michael Gapen delve into the intricate effects of tariffs on the U.S. economy and bond markets. The discussion sheds light on recent developments in tariff agreements, their immediate and long-term economic implications, and the nuanced reactions within financial markets.

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Current State of Tariffs and Economic Agreements

Michael Zezas opens the conversation by addressing the current landscape of U.S. tariffs. As of August 13, the U.S. has maintained an effective tariff rate of 16%, a significant increase from the approximately 3% at the beginning of the year. While this remains higher than initial projections following the April tariffs announcement, recent agreements with major trading partners like Europe indicate a stabilization in tariff policies for the near term.

[00:50] Michael Zezas: "Now the time when investors should stay away from chasing tariff headlines and guessing what the President might do next and instead focus on assessing the impact of what's been done."

He emphasizes the importance for investors to pivot their focus from the uncertainty of future tariff changes to evaluating the tangible effects of existing tariffs on the economy and markets.

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Impact of Tariffs on Inflation

Michael Gapen provides an analytical perspective on how tariffs influence inflation, referencing the Consumer Price Index (CPI) data for July. Drawing parallels to the 2018-2019 tariff period, Gapen explains that tariffs are expected to gradually permeate the economy, initially affecting goods prices before potentially influencing service sectors indirectly.

[01:24] Michael Gapen: "Well, we did analysis on the 2018, 2019 tariff episode... it said yes, we should start seeing the effects of tariffs on those categories where the direct effect is high."

However, the July CPI data presents a mixed picture. While core goods prices did see an uptick—rising by 2.10% month-over-month—the increase was not as pronounced as anticipated in certain sectors.

[02:21] Michael Gapen: "Core goods prices rose by 2.10% on the month in June... But we didn't get as much as we thought."

He points out that sectors like new car prices remained flat, suggesting that some tariff-induced price pressures might be delayed until future product cycles (e.g., 2026 car models).

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Economic Implications Beyond Inflation

The conversation transitions to the broader economic impact of tariffs, beyond just price inflation. Gapen underscores that while tariffs are a significant factor, other elements like consumer spending and business investment also play crucial roles in economic growth.

[05:02] Michael Gapen: "It's clear the economy has moderated... a lot of that slowdown was related to spending by the consumer and a slowdown in business spending."

He attributes the economic slowdown partly to policy uncertainty stemming from fluctuating tariff policies, which affect business planning and consumer confidence.

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Tariffs and the Labor Market

Gapen elaborates on the connection between tariffs and the labor market, suggesting that increased tariffs may lead to weaker growth, which in turn could constrain hiring practices.

[04:53] Michael Gapen: "If firms can’t pass these prices along, we’ll probably get a weaker labor market."

This scenario presents a dual pathway: either inflation remains elevated due to successful price pass-throughs, or the labor market weakens as businesses grapple with increased costs.

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Tariffs' Influence on Bond Markets

Zezas and Gapen discuss the ramifications of tariffs on bond markets, particularly focusing on U.S. Treasury bonds and corporate credit.

Favorable Outcomes for Bonds

Zezas posits that if tariffs lead to weaker economic growth, the Federal Reserve might initiate rate cuts, which would be beneficial for bond yields.

[06:25] Michael Zezas: "If that's the case, then obviously this would be a favorable backdrop for owners of U.S. treasury bonds."

Additionally, in a scenario where corporate fundamentals remain strong despite lower growth, corporate credit could also perform well due to declining yields and stable credit spreads.

Potential Risks

However, Zezas warns of scenarios where economic conditions could deteriorate further, such as entering a recession, which would negatively impact corporate credit and favor government bonds.

[07:45] Michael Zezas: "If we tipped into recession... you’d expect there to be some expression of fundamental weakness and credit spreads would widen."

Moreover, in a situation where economic growth unexpectedly accelerates—potentially due to factors like an AI-driven productivity boom—bond yields might increase, adversely affecting bond returns.

[08:50] Michael Zezas: "That would appear to be most likely in the scenario where US growth actually ticks higher, resetting expectations for monetary policy in a more hawkish direction."

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Future Outlook and Investor Considerations

Gapen discusses various future scenarios influenced by tariffs, including the potential for Federal Reserve policy adjustments in response to labor market conditions and inflation trends.

[08:12] Michael Gapen: "We can say, yes, tariffs should slow down growth... The Fed maybe eases rates as a preemptive measure..."

He outlines a possible trajectory where the Fed may adopt an accommodative stance to mitigate labor market softness, even as inflation remains a concern, influencing bond market dynamics adversely.

Zezas adds that investors should remain vigilant about the evolving economic indicators and policy responses that could sway bond yields in either direction.

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Conclusion

The episode concludes with an emphasis on the complexity and interconnectivity of tariffs with various economic indicators and financial markets. Zezas and Gapen highlight the importance for investors to adopt a nuanced approach, considering both direct and indirect effects of tariffs, as well as potential policy responses from the Federal Reserve.

[10:01] Michael Zezas: "That makes perfect sense to us. Well, Michael, thanks for taking the time to talk with me."

The hosts encourage listeners to closely monitor economic data releases and policy changes to navigate the uncertain terrain shaped by tariff policies.

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Key Takeaways

• Tariff Stabilization: Recent agreements indicate a temporary stabilization of tariff rates, reducing near-term uncertainty.

• Inflation Dynamics: Tariffs are contributing to rising goods prices, though the impact varies across sectors and may become more pronounced over time.

• Economic Growth: Tariffs are exerting a moderating effect on economic growth, influenced by reduced consumer spending and business investment.

• Labor Market: There is a potential for tariffs to weaken the labor market if businesses cannot pass increased costs onto consumers.

• Bond Markets: The impact of tariffs on bond markets is contingent on Federal Reserve responses and overall economic performance, presenting both opportunities and risks for different bond categories.

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Notable Quotes

• Michael Zezas [00:50]: "Now the time when investors should stay away from chasing tariff headlines and guessing what the President might do next and instead focus on assessing the impact of what's been done."

• Michael Gapen [01:24]: "We did analysis on the 2018, 2019 tariff episode... it said yes, we should start seeing the effects of tariffs on those categories where the direct effect is high."

• Michael Gapen [04:53]: "If firms can’t pass these prices along, we’ll probably get a weaker labor market."

• Michael Zezas [06:25]: "If that's the case, then obviously this would be a favorable backdrop for owners of U.S. treasury bonds."

• Michael Zezas [08:50]: "That would appear to be most likely in the scenario where US growth actually ticks higher, resetting expectations for monetary policy in a more hawkish direction."

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This episode of Thoughts on the Market provides a comprehensive analysis of the current and potential future impacts of tariffs on the U.S. economy and bond markets, offering valuable insights for investors navigating these complex dynamics.

Transcript

[Michael Zezas]

Welcome to Thoughts on the Market. I'm Michael Zezas, global head of fixed income research and Public Policy Strategy.

[Michael Gapen]

And I'm Michael Gapen, chief U.S. economist.

[Michael Zezas]

Today, how are tariffs impacting the economy and what it means for bond markets? It's Wednesday, August 13th at 10:30am in New York. Michael, we've been talking about how the near term uncertainty around tariff levels has come down. Tariff deals are of course still pending with some major US trading partners like China, but agreements are starting to come together. And though there's lots of ways they could break over time, in the near term, deals like the one with Europe signal that the US might be happy for several months with what's been arranged. And so the range of outcomes has shrunk. The US's current effective tariff rate of 16% is about where we thought we'd be at year end, but that's substantially higher than the roughly 3% we started the year with. So not as bad as it looked like it could have been after tariffs were announced on April 2, but still substantially higher. Now's the time when investors should stay away from chasing tariff headlines and guessing what the President might do next and instead focus on assessing the impact of what's been done. With that as the backdrop, we got some relevant data yesterday. The Consumer Price Index for July. You were expecting that this would show some clear signs of tariffs pushing prices higher. Why was that?

[Michael Gapen]

Well, we did analysis on the 2018, 2019 tariff episode. So in looking at the input output tables, which give you an idea of how prices move through certain sectors of the economy, and applying that to the 2018 episode of Tariffs, we got the result that you should see some tariff inflation in June and then sequentially more as we move into the late summer and the early fall. So the short answer, Mike, is a model based plus history based exercise that said yes, we should start seeing the effects of tariffs on those categories where the direct effect is high. So that'd be most of your goods categories over time. As we move into later this year or early next year, it'll be more important to think about indirect effects if any.

[Michael Zezas]

Got it. So the July CPI data that came out yesterday then, did it corroborate this view?

[Michael Gapen]

Yes and no. So I'm an economist, so I have to do a two handed view on this. So yes, always fair, always yes. So yes, core goods prices rose by 210 on the month in June. They also rose by 2 10. Prior to this, goods prices were largely flat with some of the big durables items like autos Being negative. Right. The give back following Covid. So the prior trend was flat to negative. The last two months they've shown 2, 10 increases and we've seen upward pressure on things like household furnishings, apparel. We saw a strong used car print this month, motor vehicle and repairs. So all of that suggests that tariffs are starting to flow through. Now we didn't, on the other hand is we didn't get as much as we thought. Now new car prices were flat. It may be that those price increases will be delayed until models, the 2026 models start hitting a lot. That would be September or later. And we didn't actually I said apparel, Apparel was up stronger last month. It really wasn't up all that much this month. So the CPI data for July corroborated the view that the inflation pass through is happening where I think it didn't answer the question is how much of it are we going to get and should we expect a lot of it to be front loaded? This going to be a longer process.

[Michael Zezas]

Got it. And then does that mean that tariffs aren't having the sort of aggregate impact on the economy that many thought they would or is maybe the composition of that impact different? So maybe prices aren't going up so much, but companies are managing those costs in other ways. How would you break that down?

[Michael Gapen]

We would say and our view is that yes, we have written down a forecast and we used our modeling in the 2018, 2019 episode to tell us what's a reasonable forecast for how quickly and to what degree these tariffs should show up in inflation. But obviously this has been a substantial move in tariffs. They didn't start all at once. They've come in different phases and there's a lot of lags here. So I just, I just think there's a wide range of potential outcomes here. So I wouldn't conclude that tariffs are not having the effect we thought they would. I think it's way too early and would be incorrect to conclude just because we've had relatively modest tariff pressures in June and July inflation, that we can be sanguine and say it's not a big deal and we should just move on.

[Michael Zezas]

And even so, is it fair to say that there's still plenty of evidence that this is weighing on growth in the way you anticipated?

[Michael Gapen]

I think so. I mean it's clear the economy has moderated. If we kind of strip out the volatility in trade and inventories, final sales to domestic purchasers was one and a half in the first quarter, is 1.1 in the second quarter. And a lot of that slowdown was related to spending by the consumer and a slowdown in business spending. So that could be a little more maybe about policy uncertainty and not knowing exactly what to do and how to plan. But it also, we think, is reflected in a slowdown in the pace of hiring. So I would say you got the policy uncertainty shock first. That also came through the effect of the April 2 Liberation Day tariffs, which probably caused a freeze in hiring and spending spending activity for a bit. And now I would say we're moving into the part of the world where the actual increase in tariffs are going to happen. So we'll know whether or not firms can pass these prices along or not. If they can't, we'll probably get a weaker labor market. If they can, we'll continue to see it in inflation. But Mike, let me ask you a question. Now you've had all the fun. Let me turn the table.

[Michael Zezas]

Fair enough.

[Michael Gapen]

How much does it matter for you or your team whether or not these tariffs are pushing prices higher and or delaying cuts from the Fed? How do you think about that on your side?

[Michael Zezas]

Yeah. So this question of composition and lags is really interesting. I think though that if the end state here is as you forecast, that will end up with weaker growth and as a consequence the Fed will embark on a substantial rate cutting program, then the direction of travel for bond yields from here is still lower. So if that's the case, then obviously this would be a favorable backdrop for owners of U.S. treasury bonds. It's probably also good news for owners of corporate credit. But the story's a bit trickier here. If yields move lower on weaker growth, but we ultimately avoid a recession, this might be the sweet spot for corporate credit. You've got fundamental strength holding that limits credit risk and so you get performance from all in yields declining, both the yield expressed by the risk free rate as well as the credit spread. But if we tipped into recession, then naturally we'd expect there to be a repricing of all risk in the market. You'd expect there to be some expression of fundamental weakness and credit spreads would widen. So government bonds would have been a better product to own in that environment. But of course, Michael, we have to consider alternative outcomes where yields go higher and this would turn into a bad environment for bond returns. That would appear to be most likely in the scenario where US growth actually ticks higher, resetting expectations for monetary policy in a more hawkish direction. So what do you think investors should watch for that would lead to that outcome? Is it Something like an AI productivity boom or maybe something else that's not on our radar.

[Michael Gapen]

Yeah. So I think that is something investors do have to think about. And let me frame one way to think about that, where ex post any easing by the Fed as early as September might be retroactively viewed as a policy mistake. We can say, yes, tariffs should slow down growth, and maybe that happens in the second half of this year. The Fed maybe eases rates as a preemptive measure or risk management approach to avoid too much weakness in the labor market. So even though the Fed is seeing firming inflation now, which it is, it could ease in September, maybe again in December, because it's worried about the labor market. So maybe that's what dominates 2025 and like you said, perhaps in the very near term continues to pull bond prices lower. But what if we get into 2026 and the tariff effect or the tariff drag on growth fades and the consumer begins to accelerate? So we don't have a recession, we just get a bit of a divot in growth and then the economy recovers, then fiscal policy kicks in. Right. We don't think the one Big Beautiful Bill act will provide a lot of stimulus, but we could be wrong. It could kickstart animal spirits and bring forward a lot of business spending. And then maybe AI, as you said, that could be a combining factor and financial conditions would be very easy in that world, in part given that the Fed has eased. Right. So that could be a world where growth is modest, but it's firming inflation that's moved up to about 3% or maybe a little bit higher later this year, kind of stays there and then retroactively. The problem is the Fed eased financial conditions into that and inflation's kind of stuck around 3%. Bond yields, at least the long end, would probably react negatively in that world.

[Michael Zezas]

Yeah, that makes perfect sense to us. Well, Michael, thanks for taking the time to talk with me.

[Michael Gapen]

Thanks for having me on, Mike.

[Michael Zezas]

And to our audience. Thanks for listening. If you enjoy thoughts on the market, please leave us a review and tell your friends about the podcast. We want everyone to listen.

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