The Downside Risks of Reciprocal Tariffs

Summary

Podcast Summary: Thoughts on the Market Episode: The Downside Risks of Reciprocal Tariffs
Release Date: February 20, 2025
Host/Author: Morgan Stanley

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Introduction

In this episode of Thoughts on the Market, Morgan Stanley’s Global Chief Economist, Seth Carpenter, delves into the potential adverse effects of reciprocal tariffs on the U.S. economy. Carpenter provides a comprehensive analysis of how increased tariffs, particularly those targeting China, could undermine economic growth, despite the market’s current focus on the inflationary impacts of such trade policies.

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Downside Risks of Tariffs to the U.S. Economy

Seth Carpenter opens by addressing the predominant concern surrounding tariffs — their inflationary pressures. However, he emphasizes that the negative implications on economic growth are equally, if not more, significant yet often overlooked.

“The inflationary risk of tariffs gets its due attention in markets, but the adverse growth implications? That's an underappreciated risk.” [01:04]

Carpenter warns that the escalation of reciprocal tariffs could pose a substantial threat to the U.S. economic forecast for the year. He underscores that while markets have adjusted to some extent, the broader growth implications remain underestimated.

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Surprising Growth Forecasts and Potential Upside Risks

Reflecting on prior economic forecasts, Carpenter admits that many analysts, including Morgan Stanley, were taken aback by the unexpected economic growth in 2023 and 2024. He questions whether there might be overlooked positive factors that could further bolster the economy.

“Maybe we should ask, are there some upside risks that we're missing?” [01:30]

One prominent upside he identifies is the surge in productivity driven by advancements in Artificial Intelligence (AI). Morgan Stanley remains optimistic about AI’s role in enhancing productivity beyond pre-COVID levels, potentially contributing an additional 0.1 percentage points to productivity growth within the year.

“We penciled in about a 10th percentage point of extra productivity growth this year from AI.” [02:30]

Additionally, Carpenter notes that AI-related capital expenditure (capex) spending could provide a modest boost to Gross Domestic Product (GDP), further supporting economic growth despite the headwinds from tariffs.

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Impact of Reciprocal Tariffs on Industrial Production

Carpenter discusses the historical context of tariffs, specifically referencing the tariffs imposed on China. He highlights how these tariffs significantly dampened industrial production in the U.S., extending their adverse effects well into 2019.

“The tariffs imposed before on China led to a sharp deterioration in industrial production.” [03:20]

Moreover, the absence of a subsequent rebound in industrial output suggests that the expected benefits of producing more domestically were not realized to the extent projected. This points to the complexities and real-world challenges of reversing decades-long trade imbalances through tariff policies.

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Global Implications of Reciprocal Tariffs

Expanding the scope beyond the U.S., Carpenter emphasizes that reciprocal tariffs could have far-reaching consequences globally, particularly affecting Latin America and Asia. He explains that many key economies have imposed higher tariffs on U.S. goods compared to the tariffs the U.S. has placed on theirs, exacerbating global trade tensions.

“Free trade has divided production functions around the world, but it's also driven large trade imbalances.” [03:50]

Carpenter warns that attempting to swiftly address these long-standing trade imbalances through reciprocal tariffs could lead to significant disruptions in international trade dynamics, further complicating economic recovery efforts.

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Baseline Outlook and Future Prospects

Despite the rising risks, Carpenter maintains Morgan Stanley’s baseline outlook that only tariffs on China are likely to remain persistent. He suggests that any delayed implementation of reciprocal tariffs aligns with this perspective, although the potential for broader tariff implementations cannot be dismissed entirely.

“Ultimately, though, we are retaining our baseline view that only tariffs on China will prove to be durable.” [04:30]

Carpenter concludes by reiterating the importance of monitoring global trade policies and their implications, both domestically and internationally, as the U.S. navigates the complexities of reciprocal tariffs.

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Conclusion

Seth Carpenter’s analysis provides a nuanced understanding of the multifaceted impacts of reciprocal tariffs on the U.S. economy. While acknowledging the potential for AI-driven productivity gains to offset some negative effects, he cautions against underestimating the significant risks tariffs pose to economic growth and global trade stability. This episode serves as a crucial reminder for policymakers and investors alike to consider both the immediate and long-term consequences of escalating trade tensions.

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Notable Quotes Summary

• “The inflationary risk of tariffs gets its due attention in markets, but the adverse growth implications? That's an underappreciated risk.” — Seth Carpenter [01:04]
• “Maybe we should ask, are there some upside risks that we're missing?” — Seth Carpenter [01:30]
• “We penciled in about a 10th percentage point of extra productivity growth this year from AI.” — Seth Carpenter [02:30]
• “The tariffs imposed before on China led to a sharp deterioration in industrial production.” — Seth Carpenter [03:20]
• “Free trade has divided production functions around the world, but it's also driven large trade imbalances.” — Seth Carpenter [03:50]
• “Ultimately, though, we are retaining our baseline view that only tariffs on China will prove to be durable.” — Seth Carpenter [04:30]

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Further Engagement

Morgan Stanley encourages listeners to share their feedback through their listener survey, contributing to continuous improvement of the podcast while supporting the Feeding America organization. For more insights and detailed analyses, listeners are invited to explore additional episodes and research provided by Morgan Stanley.

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Disclaimer: The content discussed in this podcast is for informational purposes only and does not constitute financial or legal advice. It does not take into account individual financial circumstances and objectives and may not be suitable for all listeners.

Transcript

[A]

Hi, I'm Michael Zesus, Global Head of Fixed Income Research and Public Policy Strategy at Morgan Stanley. Before we get into today's episode, the team behind Thoughts on the Market wants your thoughts and your input. Fill out our listener survey and help us make this podcast even more valuable for you. The link is in the show notes and you'll hear it at the end of the episode. Plus, help us help the Feeding America organization. For every survey completed, Morgan Stanley will donate $25 toward their important work. Thanks for your time and support onto the show.

[B]

Welcome to Thoughts in 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 10:00am 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 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 10th 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 US 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 US but around the world for Latin America and Asia in particular. Key economies have higher tariffs applied 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 podcast, help us make it even more valuable to you. Share your your feedback on the [e-mail] podcastsurvey or head to the episode notes for the survey link.

[C]

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