The Downside Risks of Reciprocal Tariffs

02/20/25 • 4 min

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Our Global Chief Economist Seth Carpenter explains the potential domino effect that President Trump’s reciprocal tariffs could have on the U.S. and global economies.

----- Transcript -----

Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist, and today I'm going to talk about downside risks to the U.S. economy, especially from tariffs.

It's Thursday, February 20th at 10am in New York.

Once again, tariffs are dominating headlines. The prospect of reciprocal tariffs is yet one more risk to our baseline forecast for the year. We have consistently said that the inflationary risk of tariffs gets its due attention in markets but the adverse growth implications that's an underappreciated risk.

But we, like many other forecasters, were surprised to the upside in 2023 and 2024. So maybe we should ask, are there some upside risks that we're missing?

The obvious upside risk to growth is a gain in productivity, and frequent readers of Morgan Stanley Research will know that we are bullish on AI. Indeed, the level of productivity is higher now than it was pre-COVID, and there is some tentative estimate that could point to faster growth for productivity as well.

Of course, a cyclically tight labor market probably contributes and there could be some measurement error. But gains from AI do appear to be happening faster than in prior tech cycles. So, we can't rule very much out. In our year ahead outlook, we penciled in about a-tenth percentage point of extra productivity growth this year from AI. And there is also a bit of a boost to GDP from AI CapEx spending.

Other upside risks, though, they're less clear. We don't have any boost in our GDP forecast from deregulation. And that view, I will say, is contrary to a lot of views in the market. Deregulation will likely boost profits for some sectors but probably will do very little to boost overall growth. Put differently, it helps the bottom line far more than it helps the top line. A notable exception here is probably the energy sector, especially natural gas.

Our baseline view on tariffs has been that tariffs on China will ramp up substantially over the year, while other tariffs will either not happen or be fleeting, being part of, say, broader negotiations. The news flow so far this year can't reject that baseline, but recently the discussion of broad reciprocal tariffs means that the risk is clearly rising.

But even in our baseline, we think the growth effects are underestimated. Somewhere in the neighborhood of two-thirds of imports from China are capital goods or inputs into U.S. manufacturing. The tariffs imposed before on China led to a sharp deterioration in industrial production. That slump went through the second half of 2018 and into and all the way through 2019 as a drag on the broader economy. Just as important, there was not a subsequent resurgence in industrial output.

Part of the undergraduate textbook argument for tariffs is to have more produced at home. That channel works in a two-economy model. But it doesn't work in the real world.

Now, the prospect of reciprocal tariffs broadens this downside risk. Free trade has divided production functions around the world, but it's also driven large trade imbalances, and it is precisely these imbalances that are at the center of the new administration's focus on tariffs. China, Canada, Mexico – they do stand out because of their imbalances in terms of trade with the U.S., but the underlying driving force is quite varied. More importantly, those imbalances were built over decades, so undoing them quickly is going to be disruptive, at least in the short run.

The prospect of reciprocity globally forces us as well to widen the lens. The risks aren't just for the U.S., but around the world. For Latin America and Asia in particular, key economies have higher tariff supply to U.S. goods than vice versa.

So, we can't ignore the potential global effects of a reciprocal tariff.

Ultimately, though, we are retaining our baseline view that only tariffs on China will prove to be durable and that the delayed implementation we've seen so far is consistent with that view. Nevertheless, the broad risks are clear.

Thanks for listening. And if you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Our Global Chief Economist Seth Carpenter explains the potential domino effect that President Trump’s reciprocal tariffs could have on the U.S. and global economies.

----- Transcript -----

It's Thursday, February 20th at 10am in New York.

But we, like many other forecasters, were surprised to the upside in 2023 and 2024. So maybe we should ask, are there some upside risks that we're missing?

Part of the undergraduate textbook argument for tariffs is to have more produced at home. That channel works in a two-economy model. But it doesn't work in the real world.

So, we can't ignore the potential global effects of a reciprocal tariff.

Thanks for listening. And if you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Previous Episode

A Rollercoaster Housing Market

Our co-heads of Securitized Products Research, James Egan and Jay Bacow, explain how the increase in home prices, a tight market supply and steady mortgage rates are affecting home sales.

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James Egan: Welcome to Thoughts on the Market. I'm Jim Egan, co-head of Securitized Products Research at Morgan Stanley.

Jay Bacow: And I'm Jay Bacow, the other co-head of Securitized Products Research at Morgan Stanley.

Today, a look at the latest trends in the mortgage and housing market.

It's Wednesday, February 19th, at 11am in New York.

Now, Jim, there's been a lot of headlines to kick off the year. How is the housing market looking here? Mortgage rates are about 80 basis points higher than the local lows in September. That can't be helping affordability very much.

James Egan: No, it is not helping affordability. But let's zoom out a little bit here when talking about affordability. The monthly payment on the medium-priced home had fallen about $225 from the fourth quarter of 2023 to local troughs in September. About a 10 percent decrease. Since that low, the payment has increased about $150; so, it's given back most of its gains.

Importantly, affordability is a three-pronged equation. It's not just that payment. Home prices, mortgage rates, and incomes. And incomes are up about 5 percent over the past year. So, affordability has improved more than those numbers would suggest, but those improvements have certainly been muted as a result of this recent rate move.

Jay Bacow: Alright. Affordability is up, then it’s down. It’s wrong, then it’s right. It sounds like a Katy Perry song. So, how have home sales evolved through this rollercoaster?

James Egan: Well, you and I came on this podcast several times last year to talk about the fact that home sales volumes weren't really increasing despite the improvement in affordability. One point that we made over and over again was that it normally takes 9 to 12 months for sales volumes to increase when you get this kind of affordability improvement. And that would make the fourth quarter of 2024 the potential inflection point that we were looking for. And despite this move in mortgage rates, that does appear to have been the case. Existing home sales had a very strong finish to last year. And in the fourth quarter, they were up 8 percent versus the fourth quarter of 2023. That's the first year-over-year increase since the second quarter of 2021.

Jay Bacow: All right. So that's pretty meaningful. And if looking backward, home sales seem to be inflecting, what does that mean for 2025?

James Egan: So, there's a number of different considerations there. For one thing, supply – the number of homes that are actually for sale – is still very tight, but it is increasing. It may sound a little too simplistic, but there do need to be homes for sale for homes to sell, and listings have reacted faster than sales. That strong fourth quarter in existing home sales that I just mentioned, that brought total sales volumes for the year to 1 percent above their 2023 levels. For sale inventory finished the year up 14 percent.

Jay Bacow: Alright, that makes sense. So, more people are willing to sell their home, which means there's a little bit more transaction volume. But is that good for home prices?

James Egan: Not exactly. And it is those higher listings and our expectation that listings are going to continue to climb that's been the main factor behind our call for home price growth to continue to slow. Ultimately, we think that you see home sales up in the context of about 5 percent in 2025 versus 2024.

Our leading indicators of demand have softened, a little, in December and January, which may be a result of this sharp increase in rates. But ultimately, when we look at turnover in the housing market, and we're talking about existing sales as a share of the outstanding homes in the U.S. housing market, we think that we're kind of at the basement right now. If we're wrong in our sales volume call, I would think it's more likely that there are more sales than we think. Not less.

Jay Bacow: Let me ask you another easy question. How far would rates have to fall to really incentivize more supply and/or demand in the housing market?

James Egan: That's the $45 trillion question. We think the current housing market presents a fascinating case study in behavioral economics. Even if mortgage rates were to decline to 4.5 percent, only 35 percent of people would be in the money. And that's still over 200 basis points from where we are today.

That being said, we think it's unlikely that mortgage rates need to fall all the way to that level to unlock the housing market. While the lack of a...

Next Episode

How a Potential Ukraine Peace Deal Could Impact Airlines

Our Hong Kong/China Transportation & Infrastructure Analyst Qianlei Fan explores how a potential peace deal in Ukraine could reshape the global airline industry.

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Welcome to Thoughts on the Market. I’m Qianlei Fan, Morgan Stanley’s Hong Kong/China Transportation Analyst. Today’s topic is how a potential peace deal in Ukraine could affect global airlines.

It’s Friday, February 21st, at 2pm in Hong Kong.

The situation remains fluid, but we believe a potential peace deal in Ukraine could have broad implications for the global airline industry. From the reopening of Russian airspace to potential changes in fuel prices and flight routes, there are many variables at play.

Russian airspace is currently off-limits due to the conflict, but a peace agreement could change that. The reopening of Russian airspace would be a significant catalyst for global airlines, reducing travel times and fuel consumption on routes between Europe, North America, and Asia.

Fuel prices account for 20-40 per cent of airlines' costs, so any changes can have a significant impact on their bottom line. We believe a peace deal could lead to a moderate fall in fuel prices, benefiting all airlines, but particularly those with high-cost exposure and low margins.

There could also be specific regional implications. The European air travel market could benefit significantly from an end to the Ukraine conflict. The reopening of Russian airspace would improve European airlines’ competitiveness on Asian routes, while a fall in fuel prices would reduce their operating costs. There would also be lower congestion in the intra-European market.

Asian airlines, particularly Chinese ones, could experience a mixed impact. On the one hand, they could see an increase in wide-body utilization and passenger numbers if more direct flights to the U.S. are introduced. On the other hand, losing their advantage over European airlines of flying through Russian airspace would be negative. But, at the same time, Chinese airlines should remain competitive on pricing given meaningfully lower labor costs.

U.S. airlines could also benefit in two significant ways. They could see a boost in revenues from adding back profitable routes such as U.S. to India or U.S. to South Korea that may have been suspended. Being able to fly directly over Russia would mean shorter, more direct flight paths resulting in less fuel burn and lower costs. U.S. airlines could also see a cost decrease from a moderate fall in jet fuel prices.

Finally, Latin American carriers could also benefit from a peace deal. If global carriers reallocate capacity to China, it could tighten the market even further, creating an attractive capacity environment for the LatAm region.

We’ll continue to bring you relevant updates on this evolving situation.

Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.