When a key economic input suddenly becomes scarce, it’s called a supply shock: It pushes costs up and economic activity down.
This helps explain why markets have responded so badly to President Donald Trump’s announcement of a 25% tariff on steel imports and 10% on aluminum. Like a geopolitical shock that reduces the supply of oil, it’s bad for both inflation and growth.
To be sure, the direct macroeconomic effect of Mr. Trump’s tariffs look to be slim. Net imports of steel and aluminum are about 0.2% of gross domestic product, compared with 0.3% for oil. Barclays estimates the tariff will add 0.1 percentage point to inflation and subtract 0.1 to 0.2 percentage point from economic growth, for one year.
But those small direct impacts are exacerbated by what the tariffs symbolize for Mr. Trump’s agenda and the broader global economy. By following his nationalist instincts Mr. Trump has broken with the pro-business factions in his administration and his party whose policy priorities have been critical to the upswing in business and investor sentiment since he was elected. By willingly hurting U.S. allies over a problem of overcapacity that is mainly China’s doing, he’s cast further uncertainty over the U.S. role as global leader.
Market action over Thursday and Friday neatly captures these cross currents.
Shares of steel and aluminum makers went up, while shares of companies that consume them, such as automobile, aircraft and construction equipment makers went down. Because consumers are more important to the economy than producers, the overall market went down.
With investors already on edge about Federal Reserve interest rate increases, the steel tariffs at the margin compound inflation pressure. That effect is so far too small to alter the Fed’s calculus, but a tit-for-tat cycle of retaliation could lead to even more inflation and rate increases than investors or the Fed have anticipated.
Mr. Trump says the U.S. needs to produce more steel and aluminum at home to safeguard national security. If so, that comes at a price, just as Japan’s longtime insistence on growing its own rice cost the Japanese in pricier food.
Firms can produce more at lower cost by serving a global rather than just a domestic market. Protectionism shrinks markets, raises costs, and reduces how fast a country can grow without generating inflation. U.S. steel and aluminum companies can meet the demand previously filled by imports, but with unemployment at a 17-year low that may require hiring workers away from other industries, putting upward pressure on wages.
This is good news in the short run for workers, but bad news for any consumer who must now pay more for cars or beer cans. Thus on Thursday and Friday, Treasury bond yields began to discount slightly higher inflation and slightly slower growth.
Because tariffs reduce the foreign currency needed to buy imports they are supposed to lead to a stronger dollar, but in fact the dollar fell in the wake of the tariff news. Investors speculated that the angry reaction of American allies, in particular the European Union, showed U.S. global leadership is fading and with it the dollar’s appeal as a reserve currency.
“If you start a global trade war, the dollars required for global trade activity falls,” said one fund manager.
The tariffs may also lead to a broader rethink of just how beneficial Mr. Trump is to the economy. Mr. Trump campaigned as a nationalist whose anti-immigration and anti-free trade views were at odds with business and establishment Republicans. Once in office, he hired business executives and prioritized deregulation and tax cuts. That is one reason surveys of business sentiment are so buoyant relative to actual economic activity. But that pro-business side is now taking a back seat to a less business-friendly nationalist agenda, which is denting investor sentiment.
It may be premature to predict a long-term impact. The tariffs haven’t been finalized and Mr. Trump could yet soften the sting. China may move more quickly to curb its overcapacity, the root of the import surge and price pressure that is hurting U.S. producers. Yet the decision has generated conflict within his own administration, his party and with key U.S. allies that, at least at the margin, counteracts the boost from the rest of his agenda.
Write to Greg Ip at greg.ip@wsj.com
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