Şebnem Kalemli-Özcan delivers a public lecture on the economic impact of international tariffs and industrial policies under the Trump administration. For background information, please read the "Global Networks, Monetary Policy and Trade" paper (PDF download).
MELANI CAMMETT: Welcome, everyone, to this special event of the Weatherhead Center entitled Trade and Inflation in a Fragmented World. My name is Melani Cammett. I'm the Director of the Weatherhead Center and a professor in the government department. When our esteemed speaker and I first started talking about this event, it was months ago, and we had no idea how timely it was going to be. Although I guess your work is always timely, but let's say it's particularly timely right now in our current economic predicament. And so I'm really looking forward to hearing your breakdown, the expert breakdown of our current global trade war and the ramifications.
So let me just give a brief-ish introduction. There's a lot to say. Professor Sebnem Kalemli-Ozcan-- forgive me for not perfect pronunciation-- is the Schreiber Family Professor of economics at Brown University and the director of the Global Linkages Lab at Brown. She's also a member of our advisory committee here at the Weatherhead Center, and we're really honored to have her there. And is the former Neal Moskowitz endowed chair at the University of Maryland, College Park. She's a research associate at the NBER and a research fellow at the Center for Economic Policy Research.
Currently, she's the co-editor of the American Economic Journal of Macroeconomics and serves on the editorial board of the AER and serves on a number of advisory panels like at the New York Federal Reserve, the Bank of International Settlements, and so forth. So, in other words, we have a real expert on our hands.
I could go on and on about the positions she's held at various international organizations like the IMF, but for the sake of brevity, I will stop there. You can look up her impressive bio online. But I do want to mention that she was the first Turkish social scientist to receive the Marie Curie IRG prize in 2008 for her research on European financial integration.
Her research focuses on international capital flows, macroeconomic fluctuations, economic growth, and the paper on which this talk is based is available online. We've shared it with you. So feel free to look at that. We've asked her to tone down some of the technical components, since it's a mixed audience. And so please feel free to check it out if you want to engage more deeply with the technical aspects.
So I'm going to turn it over to Sebnem. She's going to speak for about half an hour and then field her own questions, and we'll go to about 5:45. So thank you so much for joining us.
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SEBNEM KALEMLI-OZCAN: Thank you very much. Everyone can hear me? Great. It's a pleasure to be here at Weatherhead Center and give you this talk during these uncertain times on such a topic, and especially great to be at Harvard. I want to say yay, Harvard. So thank you so much, again, for inviting me.
So yeah, let's talk about trade and inflation and fragmented world. I'm just going to start very simply with this figure. This is the supply chain trade. So as you know, when we talk about trade, we talk about trade in cars and avocados, but also we talk about trade in semiconductors and plastics and chips and all that. So what trade economists actually call this global value chain. We have actually Pol Antras here, who was influential in describing this to us many, many years ago.
Now, after COVID, this has become known as supply chain trade. And this is how the supply chain trade looked like before Trump administration came to power, January 2025. What do you see here? You see here six circles, balls. Each of them is a country or an economic area. US, China, Euro area, rest of the world, Mexico and Canada. The size of the circles are going to be the share of those areas GDP, in world GDP. So obviously, Mexico and Canada small here.
The color blue, so if you are light blue or dark blue, is going to tell you how much of your inputs to production is important. So that's what a supply chain is, global value chain is right. So a country dark blue like Mexico and Canada imports a lot of chips, semiconductors, plastics, glass, and all those things. And the thicker arrows, you see some arrows are thin, some arrows are thick, that will tell you how much of those inputs to your production process imported through the supply chain, but through a particular country.
So you see this thick arrow going from US to Canada, US to Mexico, from Euro area to the rest of the world, from rest of the world to China. That means those arrows are thicker than actually what is between from US to China. That means a lot of the inputs to production in Mexico and Canada actually come from the US. So that's what it tells you.
This is where we started and this is now what it is going to look like after the liberation day tariffs, assuming they go through after the 90 day pause. So what do you see here? First of all, again, I'm going to do this and this, because this will immediately make you catch the blue color. Blue color means decrease. So that there is a decrease in terms of the inputs to your production that you import from your other countries. And you see a lot of the blue colors are around the US. So either what US exports to China or what US imports from China. But the same way US exports to Euro area, what US buys from Euro area.
So everything blue is decreased going down. The thicker the blue, it is going to be a large percentage change relative to the figure I showed you before 2025. Can go up to 30% reduction of what you are getting or what you are selling to that country. The arrows go both ways.
And the reds are going to be now increase. How much you start buying from somewhere else. For example, the rest of the world is start buying from Euro area. Same with the rest of the world buying from China and so forth. You see those reds are still thin arrows, not very thick, because this is a short run impact. Things are just happening.
If you work this through long run, then you are going to see a much bigger dramatic impact. What you are going to see, you are going to see US being isolated from the rest of the world and the rest of the world start trading more and more with each other. Again, this goes through all trade, but I'm focusing here on this supply chain trade, imported inputs trade, because I would like to tie back everything to this manufacturing revival idea.
OK. Now, so how do you think about inflation, trade, and economic activity in a fragmented world? This is clearly a fragmented world, right? How do I think about inflation and economic activity in every of these countries, but specifically also for US? Because this shock, this liberation day tariffs is done in the US. It is a self-inflicted thing. It is a man made thing. And it has some justifications, such as reviving the manufacturing, increasing jobs, and changing the global trading system.
If you start with this question and if you are an economist, I am an economist, how we would like to think about these things is first thing about the shock. What is the shock? And then think about the framework. So the shock here that we are going to think is what I call globalization shock. I was originally calling this the trade shock, but it is not a trade shock. This is a globalization shock. Because the way the liberation day tariffs done indiscriminately to every country sector is very much a shock to the globalization, to the global trade and finance system that we had over the last two or three decades.
Now, if you start with this globalization shock, here is a figure that goes to 1866. This is actually estimates from the Yale Budget Lab. What are these things? This is effective tariff rate, which is calculated as custom duty revenue as a proportion of goods import. And you can see that around late 1800s, we are around 30%. A lot of people are now estimating the average tariff rate is going up from something like 2.3% in 2024 over 30%.
The effective tariff rate, as you see, come down. But the latest estimate from Yale Budget Lab is something around 22%. Almost the same level or a little bit higher than this latest episode of very high effective tariff rate of Smoot-Hawley Tariff Act in 1930s. So clearly this is showing the US level. But something that high is going to be a shock to the globalization.
And we have this shock. We heard about these tariffs taking the tariff rate up globally. There are different views among the economists, among everyone, but also among the economists coming from the trade side, macro side, finance side. It can be a trade economist, a macro economist, or a finance economist. And you can be viewing these globalization shock from different angles.
I will just give you two examples here. Paul Krugman, obviously a trade economist, he argued in a column on April 5 as basically, look, the tariffs by themselves are not that scary maybe. They don't cause recessions. They are going to make the economy less efficient. Why? Because now you are buying something cheap. You have to switch to something more expensive. This is inefficient. So that means there's a reduction in economic efficiency.
But it is not about a fall in demand. Generally when we talk about recessions, unemployment, we want to link it to a fall in demand. And Krugman says, that's not necessarily the case with tariffs. But of course, because these liberation day tariffs are done in a very unpredictable, unstable, and uncertain manner, that can, of course, create something where businesses are going to have low demand for investment, consumers are going to have low demand for consumption, and that may be something we might worry about.
Treasury Secretary Bessent, on the other hand, another trade economist, maybe you can see him as a financial economist, he's saying, I see no reason why we have to price in a recession. Why he is using this language, price in a recession, because he's coming from the markets. He has this kind of market view. And he was questioning basically when he put this quote on the interview the market meltdown. He's like, why should there be a market meltdown? There is no reason to be panicking and no reason to expect a recession. So what is going on? So this is, as you can see, completely different ends of the spectrum.
So what we would like to do is, can we bring these two things together? So we wrote down a new framework. This is joint with Can Soylu here and Muhammed Yildirim here at Harvard and Koch. And we said, OK, can we write down a framework? And a framework here is a kind of from an economist jargon a global model, a new global model, where we can bring these trade and macro views together.
So it can analyze the impact of tariffs, liberation day tariffs, tariffs done on many countries, many sectors, many goods, and also on supply chain at the same time on economic activity and inflation in the United States. And also other countries, but our first goal is to look at the United States. So our project called Global Networks Monetary Policy and Trade.
OK, let me walk you through with very simple idea behind tariffs, first of all. How do we think about tariffs? I'm going to first go through, obviously, how a trade economist think about it. Think of this as the price of a car and the quantity of a car. Just think one sector. So in my country, I have certain demand for cars and certain supply of cars. This is actually from textbook of Krugman, Obstfeld and Melitz.
So autarky there is no trade. Then you open up your country to trade. Now we trade. The price of that auto, say Ford or BMW or Chrysler or whatever, that goes down. Now, opening up the trade is in your country, you still want this many autos, but now at this price, this many auto supply. So this is imports. So you are importing this many autos from another country when you open up the trade.
Suppliers of course lose. This is this administration argument that, oh, why are we not producing more autos? Why we are buying autos from other countries? Suppliers going to lose here. But consumers benefit, right? Consumers buying autos at a lower price. And a trade economist told us consumers benefits are larger, countries are better off. So a country open to trade importing is overall better off.
Now a country imposes a tariff. And here, notice that I have large in the title. A large country like the United States imposing a tariff has the ability to manipulate the world price in its favor. So that's the starting point of the administration. So a country imposes a tariff. So now this is the tariff price. Remember, this is the world price when we open up the trade. This is the tariff price. Now, the tariff price makes this auto more expensive. You were importing this much. Now you are importing this much. Your imports are less, because it is just more expensive now.
Now, there is also this power of this large country being the US now lowering this price. Now the foreign price is lower. So this is the domestic American consumer price. This is the foreign price. This is the tariff. Government collects revenue from that tariff. And this entire debate is about, well, if the government revenue is bigger than these losses, because now consumers lose, now consumers are subject to a more expensive car. Producers gain, because producers might produce those cars. And government gain because government collect revenue.
So this entire debate is about if these gains from trade revenue and all that compensate these losses, efficiency losses. Then where is that? And that would be the optimal tariff. So that's generally how trade economists look at this issue. By all means, it should that the formula we saw on the liberation day has nothing to do with that. That's the formula drop from the sky. I will just say that for now. And this is not that. But there is a very serious literature behind this. Try to understand that. I mean, can we really come up with an optimal tariff rate where we gain more by manipulating the prices in our favor than over our loss?
What we would like to do is, can we learn more if we add the macro side? Why do we want to add the macro side? Because in this trade world, prices are immediate. You put a tariff, your price goes up immediately in your country. The foreign price goes down immediately. But in reality, of course, price adjustment takes time. We learn this very well during the COVID. We want to somehow get that type of dynamics, how long it's going to take for prices to adjust.
Central bank is going to be a big part of this story. If tariff is going to somehow lead to higher costs, higher priced autos in my country, there can be an inflationary impulse there. My central bank, Federal Reserve, is going to react to that. So I want to understand how central bank is going to react to this type of price increases.
There can be retaliation and there can be foreign central banks, especially when the tariff is done as that they were done on the liberation day on many countries at the same time. Countries can retaliate. Or if they don't retaliate, since they are now going to be facing different prices, their central banks might react according to their own economy. So we want to understand that.
Households expectation is going to change. Now, household says, well, OK, now there is this tariff, this is going to be more expensive. Why don't I buy it immediately before the tariff arrives or why don't I postpone that consumption into the future because it's going to be more expensive? And that type of expectation is also going to impact future prices.
And also country sector heterogeneity. The way you put the tariffs, even it is done on everyone, the amounts were different. 30% on somebody, 10% on somebody, 25% on somebody. That is going to be very important when we look at this who is who of supply chain. I'm going to show you a more detailed picture. But depending on which country sector is where on the supply chain, it is going to be important if you are one of those countries who got the 30% or the 10% or the 50%.
All right. Basically, this is what we want to do. This is how the trade economists think about tariffs. And this is how the macroeconomists will think about the tariff's impact on their own economies. What is this? This is inflation. This is consumption. This is again now a demand curve and a supply curve. But you see, I have an A in front. That means aggregate demand, aggregate supply. Instead of just thinking auto price and auto quantity, now I'm thinking everything I demand and everything I supply in an economy in this figure.
And a tariff is going to do this. Tariff is going to reduce my aggregate demand in this country, and tariff is going to push this supply curve up. This means it is going to be more costly. A push up like that with tariff is everything is going to be more expensive. And you see what happens here. If you start from a point 0, which is what economists call equilibrium, as you see, you can go to higher inflation. And you can go to lower consumption. You move like this, and like this from here. So higher inflation, lower consumption.
If you were following the news today, Jay Powell gave a speech at the Economics Club in Washington, DC. And he said this is a stagflationary shock. What does it mean when a central bank governor says this might be? He said it might be, not it is yet, but he said it might be a stagflationary shock. He's exactly talking about that. We might have an inflation problem. We might have a lower consumption, lower output problem. That's what economists call stagflation.
Why that is especially a problem for a Fed governor? Jay Powell said this is going to be very, very difficult for us. Why? Because Federal Reserve in the United States has dual mandate. Dual mandate means Federal Reserve's job is price stability. So they don't like inflation. If there's inflation, they have to do something to reduce that inflation. But their other mandate is maximum employment. They also don't like unemployment. Lower consumption means unemployment.
All right. So that's what we are going to do. So basically, the question is a classic one. It goes back to 1752 to Hume, who asked, how do trade barriers affect prices and output? So trade economists, I show you in the figures, they don't emphasize the role of aggregate demand and monetary policy enough. And macroeconomists don't emphasize country asymmetry and sector heterogeneity enough.
And in our project, this kind of new global framework we are putting down on paper, we would like to bring these two approaches, two views together to go back this classical question asked by Hume in 1752, how do trade barriers affect prices and output in that country?
All right. This is going to be a figure that you will appreciate the complexity of the supply chain. So this is the blues are the trade linkages. So now I'm giving you more detail in the first figure. Again, the color coding here is going to be how open your country, how close your country. And it is actually very ironic if you look at countries like US and China, they are light blue. So they are big, but they are light blue. So they are kind of less open. They trade less relative to who relative to countries like Singapore and Ireland, much more open economies.
So this entire thing being about these two guys, where we have such a trade network with smaller but much more open countries, of course, is another interesting question. But this is a trade network. Here it's the old the final good trade and the supply chain trade. All the intermediate good trade and the final good trade is here. In the first figure, I was showing you only the input trade, intermediate input trade.
Now, this is where I separate the intermediate input trade. Because I want you to understand this is not just about what you buy from the other country. That was the original figure I showed you, when Mexico and Canada buy a lot of the inputs that go to their production process from the United States. This is the linkages among sectors. This is true for any country. Even you don't trade with anyone, this is true. This is just saying, so your whole sale retail sector might be selling to many. Your construction sector might be buying, say, from non-metal sector. How all the sectors link together. We call this input output linkages.
The color coding here is also about if these sectors tradable or not. For example, electronics or oil, dark red. These are tradable sectors. They trade their output directly. Some sectors like construction services are not tradable. But the important point here is what makes supply chains very complex and makes the domestic part and international part link is when you envision this figure inside this figure.
So envision the red figure inside the blue figure and you will understand how there is this whole domino reaction. Every sector is connected to each other. Even a given sector may not be trading directly. It is connected to another sector that is trading directly. And that sector is connected through other countries. So this is the complexity we are dealing with here.
All right. OK. So we are going to revisit this classical question. New global framework to think about propagation of globalization shock when there is a simultaneous impact on consumers' demand and production costs. World is connected, but fragmenting. That's the first figure I showed you. What do I mean by that here? Tariffs are used for geopolitical reasons. They have nothing to do with economics, nothing to do with trade deficits. But they are used, say, for certain geopolitical competition with countries like China. So that's going to be important.
Monetary policy response is going to be important. It doesn't matter for monetary policy what tariffs are used for or why they put in the first place. If tariffs, regardless of why they are there, if they end up creating inflation and unemployment in your country, central bank is going to respond to that. And that's something we put in our framework. Why? Because we would like to answer this question at the end.
Can a large country like United States change the existing trade and production linkages that are very complex? This is the blue and the red figures I showed you. Can this happen or the country ends up in isolation? So this is at the end the question we are after.
This is how we are going to think production. So imagine, again, the car sector in the United States. There is going to be all these glass, plastic, electronics, cables, chips coming from different countries, different sectors. They become the sector bundles and they go to this intermediate bundle. They combine with labor. They produce your car. So that's a way of thinking production in these type of network models. And this is a way of thinking consumption.
Again, this is, say car consumption, again, it's going to be car consumption or some other bicycle consumption. That's going to be this is your-- oh, sorry. This is your old consumption model. Car is going to be one. Groceries are going to be other. bicycles going to be another. And then they are going to be combined also inputs coming, parts of it coming from many, many countries. That's how we are going to think consumption and production. All layers of different processes.
This is what we get out of the theoretical model, which I'm not showing you the details, but this is inflation. So this is you start from 0 inflation before this shock hits you. And this is United States. This is the rest of the world. What is it that the shock makes inflation go up? What is it that shock makes inflation to go down? What are the elements of this tariff shock that will give you higher inflation in your economy or lower inflation? And you see the boxes that stuck up to the positive side is more. This is why we think most likely this is an inflationary shock. The tariff is an inflationary shock.
The experiment here is 10%. We just said this is something believable. Might end up what is sticking to country. Just US and the rest of the world. Everybody puts 10% on each other. That's one time tariff. Just the simplest case that probably any protectionist administration could have started with. One time tariff, 10% reciprocal.
And here these orange bars are all going to be these direct effects. These are the effects economists talk about, direct effect on the CPI, Consumer Price Index. Direct effect on the PPI, Producer Price Index. How expensive now to produce a good? How expensive your consumption good and all that.
The purple ones are going to come from the future. That's how the macroeconomists think. So there's going to be an expected demand in the future, expected inflation in the future. You move your consumption from today to tomorrow. All those type of channels are going to be in purple. So they can be inflationary or deflationary.
And the blue and the green is going to come from the fact that there is monetary policy response, but that response affected by all the network linkages, the green, meaning also the other countries responses. And the blue is how fast or how slow the prices adjust. What economists call stickiness in prices. Basically, the rate, the prices adjust. So you see that with something like this, US ends up with more inflation than not compared to the rest of the world.
We first said, OK, we want to take this model seriously and predict what is going to happen with these 2025 April 2 liberation day tariffs. To do that, we have to put some credibility behind the model. What would that be? Take the model to a road test on the 2018 Trump tariffs. Can our model going to be fitting the facts based on what happened in 2018? So that's what we are going to do first. We call it the 2018 road test.
What happened in 2018? If you don't remember, 2018 Trump tariffs was only on China by US. No retaliation from China. 25% permanent tariff. That's the 2018 Trump tariff. Now, you look at the inflation in US purple, China orange, and the rest of the world. There was this inflation first in the first quarter going up to not high, actually, very small. 0.08 percentage point from where you started. And then you go back to normal. It's just a short run impact. Exchange rate. The model predicts a 4% appreciation of the dollar vis a vis the Chinese currency, and around almost 3% appreciation of the dollar vis a vis the rest of the world.
This is what our model predicts. What happened in reality? Generally estimates from Federal Reserve and other academic articles is somewhere around 0.1 to 0.2 percentage point increase in inflation in 2018. So we come very close. 0.09, almost 0.10. And the dollar appreciated by 6% from June 2018 to December 2018 after the Trump tariffs in that period. And the same period, we have a 4% appreciation. So the model does pretty well to match something that happened in real life in 2008.
And the trade deficit, nothing happened. So there was a very little improvement. So this plus means an improvement in the trade deficit of US as a share to GDP. And this orange negative orange is also a little bit decrease in the Chinese surplus. But this is super, super small number. This is what happened in 2008.
All right. This is actually the administration starting point. If you were following, they said this was one of the early Bessent speeches. He says, look, we did this in 2018. No inflation. We are good to go. In fact, dollar appreciated. This protected the US consumers. US consumers end up being richer. So everything good. So we can move ahead since we didn't see any damaging thing from 2018.
Of course, notice the inconsistencies now this time around. These two are correct. That's what happened in 2018. But this administration also talks about the need for a dollar depreciation to support the reindustrialization revival of manufacturing in the US. So obviously even in terms of talking what happened and what happened give them power to move through, there are inconsistencies given the details of the current policy.
All right. Liberation day tariffs. Liberation day tariffs are going to be, of course, much larger numbers. And it's going to be important. Let me give you our headline numbers, what we find. And I'm going to walk you through the intuition behind them.
If we get the numbers exactly as they are, Mexico 25, Canada, West Europe, China authority, for all those numbers that were on that table on April 2. And if nobody retaliates, no country retaliates, we are going to find almost a 0.5% increase in US inflation, almost 1% drop in us output, 10% appreciation of the US dollar. This is with no retaliation.
If the countries retaliate, then we are going to find almost a one percentage point increase in US inflation. This number is going to put inflation right now in the United States over 4%. So we are now around 2.8, close to 4%, which is going to be very, very important for Fed. GDP drops around 2%, 1.58. And now a much lower. If there is no retaliation, 10% dollar appreciation becomes now 4.8% dollar appreciation, similar number to the 2018.
But you see, the reason for this is very different. Lower appreciation means US dollar can also depreciate. Why? Because with retaliation, of course, now you are going to bring back all the other countries' responses and other countries' monetary policy reactions.
We also analyze these threats. What is a threat? Threat is assuming this is all done for geopolitical reasons and to get some sort of leverage. The threat shock is you announce tariffs today, you remove them tomorrow. So it doesn't happen. Nothing happens. But unfortunately, because you announce them today, it feeds into consumers and businesses expectations. And that also changes things.
Even with threats, we find the 0.6 percentage point now deflation. Deflation, because now consumers want to cut their demand, because they are expecting the tariff is coming. GDP still drops 0.7% and the dollar still appreciates. Even tariff doesn't happen. And we can also generate a dollar depreciation depending on how these threads work. If they feed back to a financial shock, as happened last week, then you can, of course, have this number lower, turning to depreciation. And then here countries' estimated monetary policy response is going to be the key.
Let me show you these results one by one. Again, remember the tariffs are Euro area 20%, China 34%, Canada 25%, Mexico 25%, the rest of the world 10%. Those are the numbers we are putting in our model in all those circles. This is inflation. All countries are here. You see the US inflation is going to go up. The other countries are much worse. Mexico and Canada is very, very bad.
And that goes back to the original figure that I showed you how US, Mexico, and Canada buy a lot of inputs to production from US. A tariff immediately gives them what we call a cost plus shock. Now everything is very costly. So that's going to feed into this very large inflation numbers in Mexico and Canada. US is here.
And then output. US output is going to drop, because this again relates to this demand is now being lower. And most of the time, Mexico and Canada also drop output. Later 40 quarters out, things are going to improve.
But look at Euro area. Euro area is going to benefit from this. This is without retaliation. Because all that network is going to endogenously adjust. And because Euro area is in a very central location in supply chain, they can be in a beneficial position under this scenario. If they retaliate, of course they are going to also hurt some. But under this case, this is what is going to happen.
Exchange rates and trade deficit. Again, dollar is going to appreciate vis a vis pretty much everyone. Most actually here for vis a vis China and Euro area. And then it normalizes trade deficit. Yes, there is some improvement in trade deficit. But again, very, very small, 0.4% as a share of GDP. And then it is short run. In the long run, 40 quarters out, everybody goes back to where they started. So there isn't this long run reverting of the trade deficit.
Trade war. Now, everybody retaliates. Everything becomes much worse. I don't know if you were following, but now these are becoming bigger numbers. This figure is also we had a tiny typo on the scale, but this is also now much bigger. Now everybody is going to hurt in terms of GDP is going down and in the long run smoothing out. But Europe is now also being hurt, because symmetric retaliation, everybody puts the same tariffs.
Exchange rate and trade deficits. Again, we are going to have much lower appreciation here. And again, some similar low numbers of improvement in trade deficit for the US and same for the other countries.
OK, this is the last bit I want to show you, because we think this is very interesting. Threats. So how this work is US announces future tariffs. So they are announcing I'm going to put tariffs 90 days at the end of the road, which is what is happening right now. But 90 days come and no tariffs put. So tariffs is going to be lifted.
So this is the threat shock. And I put the actual tariff here for you to comparison. This is the dollar depreciation. Because going down means appreciation. So with the actual tariff shock, the dollar appreciates. Why? Because you are relocating the demand from Chinese cars to Teslas. People need more dollars to buy Teslas. So the dollar is going to appreciate. This is the standard tariff shock.
With the reverse threat, so when threat first happens, there is also that. But look what happens afterwards. So the positive rate means the dollar depreciating. When the threat is removed, and the dollar is going to depreciate the next period. So you are going to create this additional volatility in the dollar exchange rate.
And in terms of inflation, inflation, again, this is the actual tariff shock with no retaliation. So you go to this 0.8 number in terms of inflationary impulse. But the threat even reversed and even never implemented can give you 0.5 inflationary impulse, which means as of today, with the threat, we are going from a 2.7% inflation in the United States to something like 3.2 to 3, which means in this environment, Fed cannot cut the interest rates. So even just the threat itself is going to create that inflation. And this is result from our model, because we work with this dynamic model.
My final figure, this is, I think, very, very telling. This is employment. With the actual tariff shock, I know that the output is going to drop, consumption is going to drop. The blue is the actual shock. So I'm going to have this employment 1.5% decline in employment. What is 1% decline in employment? That is going to-- if 1% is going to correspond to 1.6 million job loss. So tariff itself is going to lead you in a short run 1.6 million job loss if tariff actually implemented.
Even if it's not implemented, because of this uncertainty and because demand changes and the businesses are going to start making plans, you are still going to have almost up to 1% drop in employment. Even tariff is not implemented. So threats themselves is very, very damaging. I mean, magnitude wise, less so. But direction wise is exactly the same effect. You are going to have unemployment. And you see there is no such thing as bringing the job back to America, manufacturing revival and all that in the long run.
OK, takeaways. Summary. Tariffs are contractionary even in the long run. This is the part that you understand. This is not something that can be used. This is not a policy tool that can be used for your re-industrialization, bringing back the jobs and all that, because it's going to be a contraction. They are inflationary. This might be just a short run effect, but still they are inflationary. And if it persists, it feeds to expectations. It is going to lead the Fed to keep the interest rates high for a long time, which is not good.
The threats themselves, because of the low demand at the time of announcement, is going to have this deflationary impact, which is interesting in itself, because it also says recession. It is slowing down the economy. But still, if you implement the actual tariffs, they are going to be inflationary.
Now, is it the appreciation or depreciation? What is going to happen to the dollar is going to depend if the other countries retaliate what the other countries' central banks do. For example, what is the European Central Bank is going to do? And also final impact on the financial markets. Maybe not with the actual implementation of tariffs, but these tariff threats are creating a lot of uncertainty and volatility. They can turn into a financial shock, as we see last week. And that can now weigh down on US dollar more to the depreciation side.
Can tariffs improve the US trade deficit? Yes, but very little for too much pain. So the improvement is so little, it's not worth the cost. Definitely not worth losing 1.6 million jobs to improve it that little.
My final slide is I want to come back to this, saying that trade policy is foreign policy. So this goes back, I believe, to the Harvard Kennedy School economist Cooper. But we know this trade policy is foreign policy. And currently in the US administration, they are both incoherent, both of them. If they are the same policy, then it is incoherent.
Now, let's go through this whole justification of the administration. So administration says, well, OK, maybe this is just only about China. And 90 days later, I'm going to lift all the others and it's all about China. And then if it is all about China, then at the end of this China US war, the US is going to win. This is not correct.
The reasoning goes like this. US exports 1/5 to China of what China exports to US. So once we stop that, this is going to kill China. This again completely ignores the macro side of this whole situation. Trade deficit, export minus imports, equals saving minus investment. Any country having a trade deficit means if this is negative, if our imports is much bigger than our exports to China, that means our investment is much bigger than our saving.
So American consumers don't save. They consume. Their demand is high. Their consumption demand is high. And China basically satisfy that demand by sending those goods to American consumers. So in that sense, this line doesn't really matter. So as long as this is not changing overall in terms of US trade deficit, this is not going to change.
Now, China exports more. That's correct. And US consumer demand is high and saving low. That's equal to that. But at the same time, US needs to borrow from China to finance this investment. That's the other side of this. If this goes through I think at this level right now, it's 200% or 245%. I can't keep track anymore what is the last level between China and the US tariffs.
But if this goes on, the fact that US imported inputs from China is three times that of China's reliance on US imports, that means a big inflationary impulse in the US. Through this cost channel, higher production costs, that is definitely going to prevent manufacturing revival. If it is the manufacturing revival what you want, this is not the way to go.
Because at the end of the day, China has a demand problem. Sure. China has low demand. US consumer has high demand. China sends us all the goods. OK, China has to adjust its domestic market where its domestic market and domestic consumers picks up that demand. That is correct. But the shock itself is a supply shock to the US. That's why it is at odds with this production, manufacturing revival, and all that type of talk.
And the final thing is, should we then even bother thinking about the formula and optimal tariffs? And so the administration came up with this formula out of the blue. Here I think it is deeper than that. It's not really it is the 25% or 200% or 30%. It is not about that. It is, I think, at the heart of it, the fact that the US can break its own trade agreements.
If the US can break USMCA, US Mexico Canada agreement, then it doesn't matter what number you come up with. If you are breaking that, that means all the past trade agreements US have and all the future ones, no matter what number we end up with, is going to be void and no value. Thank you very much.
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