This past week, the US Stock market was highly volatile. The markets had big fluctuations because of the trade tension between the United States and China. On May 10, 2019, President Trump tweeted that the United States has started levying 25% tariff on $250 billion worth of Chinese goods and products. President Trump claims that tariffs should increase the demand for US goods and also increase employment. In this week’s blog post, I will talk about how the tariffs on Chinese goods can lead to stagflation in the United States. This is going to be a long blog post, so stay with me.
Firstly, let us talk about stagflation. What is stagflation? Stagflation is an economic period of slow growth, relatively high unemployment, and rising prices (inflation). This is a scary period because the Federal Reserve neither print money (Quantitative Easing) nor drop interest rates like they did after the 2007-08 crisis. Why not? When prices are rising and if you inject more money into the economy (Quantitative Easing), the country starts experiencing hyperinflation, which leads to the currency becoming worthless. This happened to Zimbabwe in early 2000s, when it printed money during inflationary period leading to hyperinflation, which led to Zimbabwe scraping its currency and adopting US Dollar as its legal tender. Furthermore, with high inflation (during stagflation), the Federal Reserve cannot simply drop the interest rates to zero. Why not? Well, in order to fight inflation, the Federal Reserve has to increase interest rates. So, if the Feds decrease interest rates, it is going to lead to ever higher inflation. In conclusion, during stagflation, the Federal reserve is of no use; it can neither print money nor decrease interest rates, without causing other detrimental effects to the economy. This is the reason why stagflation is such a dreaded term.
Now that we know what stagflation is, let us talk about how tariffs on China could lead to stagflation in the United States. We are aware that with the tariffs on Chinese goods, the prices of those goods will go up. When you go to the grocery store, sooner or later, you will notice the prices of various goods, ranging from seafood to your perfume, have gone up (Here is a list of Chinese goods that are affected by the tariff). What is it called when prices of goods are going up? It’s called inflation. Now, this would be the perfect time for the Federal Reserve to come in and hike interest rates; inflation can be curtailed by increasing interest rates. However, economic growth slows down everytime interest rates rise; This is the sole reason why the Trump administration wants the Fed to lower interest rates. The Federal Reserve should hike interest rates at the earliest sign of a spike in inflation. However, let us assume that the Federal Reserve is under pressure of the current administration and doesn’t raise interest rates. With high prices seen across the board, people start saving money by not spending their paychecks on “useless stuff”. In other words, people would only spend money on essential goods. As the demand for non-essential goods goes down, the basic economic principles suggest that the prices of goods would go down. Afterall, prices and demand are directly related. However, the price would not go down to the previous (before tariff) levels. So, even if the demand drops, you can expect your strawberry fruit jam to be more expensive than the current price level. At this point, we can all agree that even if demand goes down, prices would not drop beyond a certain price level, which is more expensive than pre-tariff prices.
As prices stay high, people are less likely to spend their hard earned paychecks. Now, you might be fine with paying 25 cent more for your strawberry fruit jam, but think about big ticket items like a car. You are less likely to purchase a new car (or might delay your purchase) because the metals and polymers that went into manufacturing your car are now more expensive, which drove up the listed price of your new car by $8000. I hope we can agree that with these elevated prices, people’s spending habits are going to change and that people are more likely to save their money. As the spending slows down, the economy slows down. For example, as people slow down (or stop) buying new cars, the automobile industry will feel the wrath. As the automobile industry slows down, the steel and aluminum manufacturers who provided raw material for the body of the car will feel the pain. Similarly, the chemical industries (i.e. companies like Dow and BASF) that provided the fabrics and polymers that go in the interior of the car will feel the slowdown. Furthermore, all the companies that are in the supply chain of these steel, aluminum, chemical manufacturers will also be affected simply because car sales have slowed down. Right now, the only thing we are lacking for “stagflation” is high unemployment. With dwindling growth and declining profit margin, hiring is going to slow down. As hiring slows down, people get afraid of an upcoming recession. So, what do they do? They start saving like never before. They only spend on essential goods more or less needed for survival. This kind of spending habit pushes the economy into a recession. Noone is spending, so what’s the point of employing people to produce “useless” goods. What’s the point of employing pilots if noone is buying airlines tickets? Why employ truck drivers if goods don’t need to be restocked at a warehouse? As you can tell, unemployment is likely to rise at this point. Furthermore, the economy is experiencing stagflation i.e. slow growth, relatively high unemployment, and inflation. Unlike before, the Federal Reserve cannot get the United States out of this mess i.e. they can neither print money nor drop interest rates. President Trump’s claim that tariffs would increase demand for US goods and increase employment might not be so realistic afterall. In conclusion, tariffs on China equate to tariffs on the United States in the form of stagflation. Please note that the scenario that I described above is unlikely, but it is still a possibility.
Hope you learned a little and found this blog post helpful. We talked about how the tariffs on China could be detrimental to the United States. We talked about what stagflation is, and how the United States can get into stagflation. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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