- President Trump’s trade war has created material downside risks for the global economy. Our forecasts assume that tariffs on most countries outside China will stay at 10% and retaliation by other governments will be moderate. In this scenario, global GDP would be about 0.4% lower in two years’ time than in a pre-tariff baseline. However, if deals aren’t reached, pauses expire, and the US partially reverts to its Liberation Day tariffs while maintaining ~145% tariffs on China, then the hit to global GDP would be closer to 1%.
- The economic effects of tariffs will be determined by several things. For the US, a key issue will be the extent to which tariff revenue is recycled into the economy via cuts to other taxes or increases in public spending. For the rest of the world, the size of the tariff and the reliance on US demand will play a key role in determining the economic consequences. Exchange rate shifts and confidence effects will have a bearing on the economic fallout everywhere.
- Given the high degree of uncertainty around each of these factors, it makes sense to think about the economic consequences of tariffs in terms of different scenarios. Our new Tariff Impact Model (TIM) allows clients to design their own tariff scenarios and model their impact on GDP in economies around the world, as well as on the US average tariff rate and price level. In this note, we consider three scenarios: one based on our central tariff assumption and two other “high tariff” scenarios. (Details in Table 1.)
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Table 1: US Tariff Rate Scenarios |
Chart 1: Cumulative 2-Year Hit to GDP |
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CE Base Case* |
Liberation-Light |
Escalation |
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China |
63% |
145% |
222% |
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Canada |
6% |
6% |
21% |
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Mexico |
8% |
8% |
23% |
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Reciprocal^ |
10% |
17% |
24% |
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Steel & alu. |
25% |
25% |
25% |
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Autos & parts |
25% |
25% |
25% |
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Other goods+ |
0% |
0% |
25% |
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US average# |
17% |
30% |
50% |
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Retaliation |
Modest |
Modest |
Significant |
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Source: Capital Economics *CE central assumption underpinning forecasts. |
Source: Capital Economics |
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- In our central scenario upon which our forecasts are based, we assume that US tariffs on most economies stay at the 10% ‘minimum’ rate. While yesterday’s announced pause on applying full Liberation Day reciprocal tariff rates is due to expire in early July, we expect countries to have struck some form of deal by then or for the US to extend the pause indefinitely. We also assume that the eye-watering tariffs currently in place on China will be rolled back in negotiations. However, reflecting a deepening superpower rivalry between Washington and Beijing, we assume that tariffs on China remain at a much higher rate of just over 60%. The sector-specific tariffs that have been announced remain in place but do not “stack” on top of country-level tariffs. We assume that the Trump administration uses tariff revenue to lower other taxes, thus avoiding a fiscal tightening in the US. And we assume that retaliation by other countries is limited.
- In this scenario, US GDP is about 0.6% lower than its pre-tariff baseline by the end of 2026. Allowing for lower energy prices, US CPI inflation rises to 4% by the end of this year before falling back in 2026. This rise in inflation limits the room for the Fed to cut interest rates. Given the curbs on immigration, we don’t expect a slowdown in GDP growth to around 1.5% to generate any meaningful rise in the unemployment rate. That would also limit the scope for the Fed to loosen monetary policy.
- Elsewhere, a weaker renminbi and additional fiscal support will help to cushion the hit to China, but GDP is still likely to be around 0.7% lower than its pre-tariff baseline. (This assumes that the renminbi falls to 8/$). As a result, we expect the economy to expand by only 4% this year on our CAP measure of growth.
- Strong trade linkages across North America mean that even though Canada and Mexico face lower average tariff rates of 6% and 8% in our base case, there is still a substantial hit to their economies. GDP in Canada is 0.7% lower than its pre-tariff baseline in two years’ time, while in Mexico it is 0.9% below. Elsewhere, despite a large gap in tariff rates between ASEAN economies and China opening up – on the face of it making the former’s exports more competitive – we assume that ASEAN economies suffer a similar hit to GDP as that of China. This is because uncertainty surrounding US trade policy ends up denying the region most of the potential benefits that offshoring or re-routed trade from China would ordinarily offer.
- The effect on other economies is more limited, knocking around 0.2% off GDP in the EU, India, and Japan relative to pre-tariff baselines, and the UK gets away without a significant hit at all. (See Chart 1.) Global GDP is 0.4% lower than the pre-tariff baseline, meaning growth in 2025 and 2026 is 2.9% and 2.8%, respectively. Since we assume that retaliation is limited, the impact on inflation outside the US is limited. Most central banks will view the imposition of US tariffs as another reason to lower interest rates.
- Our second, ‘Liberation-Light’, scenario assumes a partial reversion to Liberation Day tariff rates and the US maintaining a 100%+ rate on China. In this scenario, reciprocal tariff pauses are extended or deals struck with some countries, but not with others, meaning that reciprocal rates applied to countries outside China average 17% – the midpoint between the 10% ‘minimum ’ and the average full Liberation Day rates. What’s more, negotiations between the US and China – if they happen at all – fail, leaving the US average tariff rate on China at its current rate of around 145% and China’s rate on the US similarly close to 100%. (Media reports talk of a 125% US tariff rate on China but, as per the executive order, this 125% is the new reciprocal rate and thus does not take account of the other tariffs the US applies to imports from China.)
- In this scenario, tariffs are viewed by Washington as a more significant and permanent form of federal government revenue. The tariff revenue is once again recycled in the form of additional tax cuts and the retaliation by other governments is limited. The economic impact on both the US and the rest of the world is bigger than in our central forecasts. The hit to US GDP is about 1.5% compared to its pre-tariff baseline over the next two years. US CPI inflation rises to 5.5% by the end of this year before falling back in 2026. Under those circumstances, the Fed may be willing to cut interest rates by a cumulative 100bp.
- Meanwhile, GDP in China falls by 1.2% relative to its pre-tariff baseline. Despite not being hit by tariff hikes themselves in this scenario, Canada and Mexico experience a hit to GDP similar to that of China owing to the indirect effects from a weaker US economy, while China’s government limits the damage to GDP by ramping up fiscal support. (See Chart 2.) Central banks are likely to respond more aggressively. For instance, the ECB could cut interest rates to 1.5%, compared to the current rate of 2.5%.
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Chart 2: Cumulative 2-Year Hit to GDP |
Chart 3: Cumulative 2-Year Hit to GDP |
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Source: Capital Economics |
Source: Capital Economics |
- The final, ‘Escalation’, scenario assumes a full reversion to Liberation Day tariffs for all countries; new 25% global product-specific tariffs on pharmaceuticals, semiconductors, copper, and lumber; Canada and Mexico losing their USMCA tariff exemptions; and the US and China pursuing bilateral autarky with even higher tariffs as well as non-tariff barriers.
- Modelling such a scenario is challenging, since there is likely to be all manner of indirect effects from the punitively high tariffs on China, such as re-routing trade through third-party countries. If the US and China were to effectively cut off trade in most if not all areas, the fallout in financial markets could conceivably take on a life of its own with large negative feedback loops on the global economy.
- Taking account of significant but not extreme financial market dislocation, in this scenario we estimate that US GDP falls by over 3% relative to his pre-tariff baseline and inflation rises to 8% by the end of this year. Despite the big rise in inflation, the greater hit to the real economy means that the Fed is more likely to cut interest rates, perhaps reducing them by 200bps. The probability of a US recession rises to more than 50%.
- Meanwhile, GDP in China falls by 1.7% relative to its pre-tariff baseline in this Escalation scenario – a bigger hit than in the Liberation-Light scenario, but only 0.5%-pt more. In large part, this reflects the fact that most of the damage to US-China trade is achieved with the 145% tariff rates that are in place today and that are assumed to stay in place in the Liberation-Light scenario. At these tariff levels, we think that exports from China to the US would fall by 80% within the next two years. Hiking tariff rates higher and implementing sweeping export controls will have a marginally smaller effect.
- With less fiscal support to cushion the blow, ASEAN economies suffer more than China in this scenario, with GDP in the region 2% lower than the pre-tariff counterfactual. Having lost their USMCA-compliance exemptions to the 25% blanket US tariffs, Canada and especially Mexico get hit hard. They fall into recession and GDP ends up 3% and almost 5% lower by the end of 2026, respectively. With China’s trade surplus diverted away from the US almost in its entirety, this exerts a disinflationary counterforce to any inflationary impulses from trade partners retaliating to US tariffs. With price pressures in check and growth weak, most central banks are in a position to lower interest rates.
- All told, in this plausible escalation scenario, global GDP ends up 1.6% lower than its pre-tariff baseline, which is roughly 1.5x what the euro-zone crisis knocked off global GDP over a decade ago. Global GDP would rise by about 2.2% in 2025 and 2.3% in 2026, which would be weaker than growth in 2008 and on par with growth in 2001 during the downturn that followed the bursting of the dotcom bubble.
- The economic outlook is clearly highly uncertain and much hangs on the extent to which countries are able to do deals with the US to negotiate tariffs lower. With that said, three general points are worth stressing. First, our sense is that the economic damage caused by tariffs under our central assumptions, while still significant, seems more limited than many now seem to expect. (This probably reflects our assumption that most tariffs are reduced.) Second, in every scenario, India, Japan, and the UK are among the smallest losers from US tariffs, while USMCA partners including the US itself are among the worst-hit. Third, developments over the past few days suggest that, whatever happens, China is likely to face much higher tariffs than other countries. Accordingly, despite exports to the US accounting for just 3% of its GDP, China fares worse than likes of Europe, India, and Japan in all our scenarios.
- It is clearly possible to conceive of many more alternative scenarios, ranging from a different set of country-specific tariffs to new product-level levies. Clients can model their own scenarios at both a country and product level using our new Tariff Impact Model (TIM).
Simon MacAdam, Deputy Chief Global Economist, simon.macadam@capitaleconomics.com
Neil Shearing, Group Chief Economist, neil.shearing@capitaleconomics.com