Research director Andrea Raffo on trade policy uncertainty, tariffs, and the flight from U.S. assets

In 2018, global trade was in the headlines more than usual: Brexit in the United Kingdom, renegotiating NAFTA, a bubbling U.S. trade spat with China. To inform the work of the Fed, economists in the International Finance Division of the Federal Reserve Board created and published, in the Journal of Monetary Economics, a new daily index of “trade policy uncertainty” (TPU) based on the prevalence of trade tensions in the news.

Among the authors was Andrea Raffo, the Minneapolis Fed’s research director since 2022. Anecdotally, households and businesses were having trouble making spending and investment decisions. The economists’ index confirmed that uncertainty over trade was far higher in 2018 than any time since at least 1960. Their theoretical model connected this measure of unpredictability to economic outcomes.

Today, the TPU index is more than three times its peak in 2018 (Figure 1).

“This level is 10 times normal business conditions,” said Raffo. Rather than a temporary surge, 2018 looks in hindsight like the opening salvo of a major transformation. Seven years later, Raffo said, the U.S. is now resuming “a renegotiation of trade arrangements that for decades had gone in the direction of more integration and lower barriers.”

Beyond the direct effect of tariffs, how is the high level of uncertainty about trade likely affecting economic activity?

Andrea RaffoLucy Hawthorn for Minneapolis Fed

In our 2018 research, we derived two key results. The first was that trade policy uncertainty can have meaningful effects on the economy. We estimated that the trade tensions of 2018 and 2019 resulted in an $800 billion loss in GDP for the world economy—about 1 percent of global output, or roughly the GDP of Switzerland.

Second, we established that this cost occurs through two channels. The first is that when there are threats of tariffs, households and firms start forming expectations about future tariffs that they need to incorporate in their plans. That effect acts exactly like an increase in tariffs. Households behave as if their purchasing power is lower, which means less demand for goods and services. Firms anticipate higher cost of inputs and lower sales, including lower foreign sales to the extent that there is a threat of retaliation. Hence, investment spending declines as well.

Then there is a second channel, which is the pure uncertainty. We know that in uncertain times, consumers become more anxious about the future, the possibility of losing in their job. They start saving more and consuming less, just to build some rainy day funds in anticipation that we may have a recession coming.

A key finding of our work is that even if higher tariffs never materialize, you can still have both of these significant impacts on the economy.

During turmoil, investors typically seek safety in U.S. Treasurys. This time, that’s not happening. Long-term bond yields are rising, and the U.S. dollar is falling against other global currencies. What are the implications for the U.S. economy?

Historically, in moments of uncertainty associated with significant declines in equity, investors globally buy more U.S. Treasurys, which are perceived as the quintessential safe asset for the global economy. And the dollar appreciates. Currently, we’re not seeing that.

The dollar is the reserve currency of the world. About 60 percent of foreign government reserves are in U.S. Treasurys. It has gone down some in recent years, but foreign investors still own about 30 percent of U.S. government bonds. The dollar is also the dominant currency used for trade invoicing. Almost all the export transactions out of the Americas are settled in dollars. In Asia, 80 percent of exports are settled in dollars.

In this context, a flight out of U.S. Treasurys and the dollar poses challenges—and I think [Minneapolis Fed] President Kashkari recently provided a very good message on this. First, it essentially implies that the recent increase in U.S. Treasury rates has nothing to do with monetary policy—instead, the increase in rates has to do with risk appetite towards U.S. Treasurys. As such, the flight from U.S. assets acts as an exogenous increase in interest rates. And that is likely to put downward pressure on the U.S. economy. Second, if sustained, this may indicate that foreign investors are rethinking whether the U.S. remains an attractive destination for their investment.

U.S. tariffs this year could reach levels higher than anything in a century (Figure 2). And there’s no clear precedent for anything like the triple-digit tariffs against China. This means that reality is now outside the range of most trade-related research. How are economists adapting to understand the effects of trade barriers on this scale?

The situation is very fluid. We are going back to our models, trying to feed in these large changes in tariffs and trace out the near-term implications for activity, employment, and inflation. Not a big surprise: Higher tariffs are “stagflationary” shocks, as they send both of the goals of monetary policy [low inflation and full employment] in undesirable directions. This poses a challenge for monetary policy.

We are looking closely at the details of the announcements—especially attending to where substitution is possible, in terms of specific sectors or goods or countries that are being taxed at differential rates. For some types of consumer goods, consumers will see almost immediately the impact of those higher tariffs on prices. To the extent that tariffs hit intermediate goods and other inputs for firms, they are likely to have a more delayed effect—but still an inflationary one because essentially costs for firms are increasing.

We’re also doing a lot of outreach to companies in the region to see how they’re experiencing and adapting to the new tariffs. The common theme is that these tariff changes are surprisingly large. Many firms are postponing investment decisions to see how much of the tariffs will ultimately be in place. For some multinationals that have organized production around multiple sites in multiple countries, the new tariffs might create much bigger challenges, because roundabout production implies that tariffs might be paid multiple times. It might even challenge the viability of those multisite, very complex production lines. Such effects are not going to be picked up in our models. This is where the discipline of the models and the information we receive in real time from our contacts provide input for our thinking.

Some countries seem to be clamoring to negotiate bilateral trade deals with the U.S. to bring down tariff rates. Is there something fundamentally different about a world in which tariffs come down in a broad and universal way versus a bunch of one-off deals with separate countries?

We are analyzing the implications of having the tariffs temporarily increase and then decrease as countries sign new trade agreements. But we don’t have yet a lot of information to put structure around some of these scenarios.

When you look at the effects of tariffs on the economy, two key features are important. First, how large is the good or the sector that you’re putting a tariff on? Second, how easy is it to substitute away from that specific provider? As of now, we have observed both an increase in the general level of tariffs and a much higher increase of tariffs on specific countries. When the general level of tariff goes up, there is very little room for substitution, so everybody is going to pay the cost. When there are higher levels on specific sectors or goods or countries, then we can start looking into who is the second-best producer for that specific item. And that might provide some attenuation of the effect of the tariff. So yes, a world in which three years down the road tariffs return to the January 2025 level and there are new trade agreements would be a world where the economic cost of the higher tariff will be smaller compared with a permanently higher level of tariffs on all imported goods.

Recent Minneapolis Fed research highlights that while developed countries like the U.S. benefit on aggregate from international trade, poorer countries gain even more. The head of the International Monetary Fund recently offered a dim picture for much of the world because of this reordering of U.S. trade. Looking beyond the U.S. economy, what implications do you see for global growth and development?

My sense from private sector and international organizations’ reports is that everybody is revising lower the outlook for global growth in the near term and revising higher the outlook for inflation. We were coming out of the highest inflationary episode since the 1970s, and both the United States and the global economy were close to achieving a soft landing. So, there is a great deal of concern about a slowdown in global activity, a pickup in inflation, and whether inflation expectations will remain anchored or not.

It’s useful to reinforce why U.S. households also win when the global economy is strong. Why would we care about how other countries do?

Linkages across countries are way more important than they were 50 years ago. To the extent that we live in a global economy in which companies sell products in the United States and abroad, anything that happens in the world affects U.S. workers directly. A reduction in activity in Europe, in China, in Latin America means lower exports and fewer jobs for Americans. It’s that simple.

When there are financial tensions or financial crises abroad, the U.S. stock market and Americans’ wealth take a hit. Moments of global uncertainty are typically moments of global sell-off. What happens abroad has consequences for the well-being of Americans.