Why tariffs will hurt US economic growth but likely won't reduce the trade deficit

This article originally appeared on our US website.

What impact could President Donald Trump’s tariff plans have on the economy?

Higher tariffs would unambiguously reduce real gross domestic product and would likely push inflation up, though the size of impact depends on other factors. Somewhat counterintuitively, we think they’re unlikely to help in reducing the trade deficit, an oft-stated goal of Trump’s.

Real GDP measures the size of economic output, so any reduction in real GDP means a reduction in living standards for the average person. And if the hit to GDP is large enough, it could cross the threshold into recessionary territory, which is why appreciation of this risk is currently roiling equity prices.

We estimate that a full implementation of a 10% uniform tariff hike and 60% tariff hike for China, as Trump proposed in his presidential campaign, would reduce the long-run level of US GDP by 1.6%.

However, it’s still far from a sure thing that tariffs of this magnitude will go into effect—and, even if they do, that they’ll be maintained for a multiyear period.

In our latest Economic Outlook, we detail the potential future of tariffs, inflation, and GDP under the Trump administration.

What tariff hikes could mean for GDP growth

Higher tariffs would unambiguously reduce real GDP. We estimate a 1.6% long-run impact: a 1.1% impact from the 10% uniform hike and a 0.5% impact from the 60% China hike. (To be clear, this represents a permanent downward shift in the level of real GDP by 1.6%.)

Although there is a greater possibility that the tariffs on Chinese goods are implemented, they would likely have a lower impact on GDP than the uniform tax hikes.

We think there is a higher chance of Trump implementing the China tariffs because of the increasing bipartisanship of anti-China sentiment, and because of the extent of similar tariffs that Trump implemented in his first term.

However, we estimate a lower impact from the China tariffs, partly because companies could likely dodge them by rerouting through third countries.

We still think the probability of these tariffs’ implementation is relatively low, and markets mostly seem to be pricing in the same estimate to their GDP forecasts.

Still, we’ve shaved 0.32% off our forecasts for cumulative real GDP growth through 2028 to account for the probability-weighted impact.

The degree to which tariffs also affect inflation and other variables depends on the fiscal and monetary policy response.

If proceeds from tariffs are used for tax cuts, the tariffs would be more inflationary, or they would lead to higher interest rates owing to the Fed’s response to inflationary pressures.
On the flip side, exchange-rate appreciation would dent the inflationary impact of tariffs, at the cost of harming US exporters.
To the extent that foreign countries retaliate with tariff hikes of their own, exchange-rate appreciation would be less likely.

The worst-case tariff hikes could erase nearly a century of trade opening

The average US tariff rate was about 2.5% in 2024, up modestly from 1.7% in 2016 (due to the tariff hikes implemented in 2018-19).

Implementation of the full 10% uniform and 60% China hikes would more than quadruple this rate to at least 15%—the highest the US has seen since the early 1930s.

Still, we think it’s more realistic that the average tariff rate rises to around 5%. As of March 13, 2025, traders on Polymarket assess about a 40% probability of this happening by the second quarter of 2025. This would be the highest rate since the early 1960s, albeit still low compared with the pre-World War II norm.

Why tariffs are unlikely to reduce the trade deficit

In part, Trump’s appetite for tariffs stems from a long-standing grievance against the size of the US current account deficit. (The current account deficit comprises the trade deficit and a few other minor items.)

However, the direct impact of tariffs is extremely unlikely to make a dent in that deficit.

Though this may seem counterintuitive, it’s a logical outcome from a basic accounting concept: The current account deficit equals the net inflow of capital.

Consider the chart below. Because the flow of capital doesn’t respond to changes in the exchange rate, increasing tariffs won’t help reduce the current account deficit. The exchange rate will adjust by appreciating, which lessens the impact of tariffs on imports and causes exports to decrease enough to maintain the current account balance.

Illustrative equilibrium in account balance

Illustrative Equilibrium in the Current Account Balance

Source: Morningstar

The only assumption we’ve made is that capital inflows won’t respond to changes in the exchange rate.

That’s because while capital inflows usually adjust to expected future exchange-rate changes, they aren’t likely to shift after a one-time exchange-rate appreciation. Thus, the standard view is that capital inflows would be essentially unchanged in this scenario.

For example, consider the US shale oil and gas boom of the 2010s. While the US historically imported more oil and gas than it exported, the advent of fracking and horizontal drilling enabled the US to increase its production and reduce its dependence on imports. Eventually, it reached a point where oil and gas imports balanced out with the value of exports.

However, the improvement in the oil and gas sector didn’t have a large impact on the US’ overall trade deficit (the extent to which a country’s imports exceed its exports). Because the effects of the shale boom caused the value of the US dollar to increase by about 20%, US exporters became less competitive while imports became more attractive—meaning the trade deficit across other goods and services substantially increased.

So, for the US to make new headway against its current account deficit, it will have to find another way to reduce the inflow of foreign capital—and that would entail a depreciation of the US dollar.

What could tariffs mean for inflation?

We project an average inflation rate of 2.0% over 2025-29, with 2025 at 2.2%, and 2026 and 2027 dipping slightly below the Fed’s 2.0% target.

This forecast takes into account the probability-weighted impact of higher tariffs, which we believe push the price level by 0.20% over 2025-28.

Full implementation of the tariffs would probably push the price level up by another 1%-2%, but as discussed above, we don’t think it’s a sure thing that they will be implemented and/or maintained.