By Howard Schneider
WASHINGTON (Reuters) - A U.S. economy praised for its surprising resilience to a pandemic, high inflation, and rapid interest rate hikes faces a new challenge from President Donald Trump's self-declared trade war, seen by economists as a recipe for fewer jobs, slower growth, and higher prices.
The fallout, assuming Trump does not backtrack in the face of falling stock markets and cracks to consumer and business sentiment, is expected to be broad, deep and time-consuming as the world's largest economy adjusts to the overnight shock of a 25% tariff on most goods coming from Mexico and Canada, both close trading partners and geographic neighbors, and an additional 10% duty on imports from China. Canada and China have announced retaliatory tariffs on U.S. imports, while Mexico is expected to do so this coming weekend.
A price shock on its face, the tariffs could also begin to kill demand, said Diane Swonk, chief economist at KPMG, particularly if consumers retreat and firms facing heightened uncertainty curb investment and hiring. The move also risks unintended consequences - if, for example, banks tighten credit on small businesses instead of extending suddenly expensive customs bonds.
A recession by the start of next year is not out of the question, Swonk said, with some analysts expecting a downturn could sweep the continent given the dependence of Canada and Mexico on exports to the U.S. market. Retaliation could further deepen the impact.
"We've got now multiple trade wars on multiple fronts," Swonk said. Her analysis shows the effective tariff rate spread across roughly $3 trillion in U.S. imports might rocket to 16% by early 2026 from a current baseline of about 3% if Trump follows through on all his threats. "That would be the highest rate since 1936," during the Great Depression, and "gets you flirting with stagflation" - the toxic mix of weak growth, high joblessness and persistent inflation that epitomized the 1970s.
While the U.S. economy is ordered differently now than in the 1930s or 1970s, the sweep of Trump's actions and the uncertainty about what comes next still unnerved markets that had hoped he was only bluffing about tariffs to gain leverage in negotiations with trading partners.
The S&P 500 index has suffered sharp losses since Trump on Monday dashed expectations for a last-minute reprieve on the tariffs, and is now down about 5.5% from its February 19 all-time high. Yields on U.S. Treasury bonds have fallen to the lowest levels since October.
Story Continues
Trump, who has railed about U.S. trade deficits and accused Canada and Mexico of failing to do enough to stem the flow of the deadly fentanyl opioid into the U.S., will address Congress on Tuesday night.
'LET'S HOLD BACK'
Members of the Trump administration have said they want lower bond yields, as that makes it cheaper to finance the government and could eventually benefit consumers through lower home mortgage and auto loan rates. But the rationale for the drop - a flight to safety from rising economic uncertainty and potential recession risks - is less than assuring.
In a sign of the darkening economic landscape, U.S. retail giant Target on Tuesday said it expected little to no sales growth this year, with CEO Brian Cornell telling CNBC that higher prices were on the way. Retail bellwether Walmart and electronics retailer Best Buy also recently warned about expectations for 2025.
"The consumer will likely see price increases over the next couple of days," Cornell said, with food imported from Mexico now hit with a 25% levy.
Jack Kleinhenz, chief economist for the National Retail Federation, said small businesses will face even more difficult choices, lacking the leverage of companies like Target to share cost increases, and are likely to pull back on investment and hiring.
"We're going to see a price level change upward," said Kleinhenz. But beyond that "it is really blurring the outlook ... The business sector is going to wait and see, and when they don't know what the future might be, they're going to say let's just hold back on investment. Let's hold back on hiring."
The potential for a quick change in the U.S. economic outlook follows a period when the country was coasting through a spell of global outperformance - with growth above trend, inflation on the decline, and more than three years with the unemployment rate lodged around or below 4%, a level many economists would consider full employment.
What happens next "isn't just a tariffs story," said Gregory Daco, chief economist at EY. It's as much a story of how Trump's actions land in an economy where the memory of recent high inflation is still fresh and pandemic-era savings buffers are likely exhausted, he said.
"The exceptionalism and resilience that we've been talking about for two years, I think is starting to show some cracks," Daco added. "We're seeing a smaller share of consumers doing a greater share of the spending, and we're noticing that whether it's sentiment or income, both important pillars to consumer spending activity, they are softening."
Daco said he now expects recessions in Mexico and Canada, and put the odds of one in the U.S. at greater than 50% if the tariffs remain in place.
NEXT UP: THE FED
The ultimate outcome will also be shaped by the Federal Reserve, and whether it sees the risk of higher inflation as more or less damaging than the possible hit to growth and any follow-on rise in joblessness.
Through much of its recent battle with inflation, the U.S. central bank had the best of both worlds, with free-spending consumers supporting growth, federal investment adding to the expansion, and inflation still falling as global supply chains righted themselves after the COVID-19 crisis.
Trump's initial actions have added to risks around all of those aspects of the economy, with fiscal support potentially turning negative amid mass firings of federal workers and cancellations of government contracts, prices under pressure from tariffs, and consumers caught in the middle.
The spark this time may be domestic trade policy, not the politics of the Middle East, but it may still leave the central bank with difficulties similar to those faced by former Fed Chair Paul Volcker of whether to risk a recession to tame inflation.
In contrast to the predominant sense, until recently, that the central bank was close to fixing inflation without paying a price in terms of slower growth, "a less favorable but plausible scenario must also be considered," St. Louis Fed President Alberto Musalem said on Monday at a National Association for Business Economics conference. "In this scenario, inflation stalls above 2% or rises while at the same time the labor market weakens."
(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)
