In the 1930s, the US Treasury Secretary Henry Morganthau was widely regarded as the finest Treasury Secretary since Alexander Hamilton. However, if the current Treasury Secretary Scott Bessent, continues to deliver results as he is doing now, he will provide formidable competition to Morganthau’s legacy.
The quality of Bessent’s work is exceptional, demonstrated by his ability to secure an agreement with China in just a few days in complex circumstances.
The concept of the "effective tariff rate" is a term that has gained traction recently. Although nominal tariff rates on individual goods in individual countries might be as high as 100% or 125%; the effective tariff rate, which reflects the actual tariffs the US imposes on imports from all countries, is thought to be only 20.5%. This figure comes from an online spreadsheet published by Fitch Ratings, since 24 April.
This effective tariff rate of 20.5% can be used in assessing the impact of import tariffs on US inflation. To evaluate this, I used a method proposed by Scott Bessent during his Senate confirmation hearing. Bessent began by noting that imports account for only 16% of US goods and services that are consumed in the US Economy. In this case, a 10% revenue tariff would increase domestic prices by just 1.6%. With a core inflation rate of 2.8% in the US, this results in a headline inflation rate of 4.4%. Thus, the overall impact of such tariffs on the US economy is relatively modest.
A couple of weeks ago, Austan Goolsbee, the President of the Chicago Fed, noted that tariffs typically increase inflation, which might prompt the Fed to lift rates, but they also reduce economic output, which might prompt the Fed to rate cuts. Consequently, Goolsbee suggested that the Federal Reserve might opt to do nothing. This prediction was successful when the Open Market Committee of the Fed, with Goolsbee as a member, left the Fed Funds rate unchanged last week.
A 90-day agreement between the US and China, masterfully negotiated by Scott Bessent, has dramatically reduced tariffs between China and the US. China now only imposes a 10% import tariff on the US, while the US applies a 30% tariff on Chinese goods—10% as a revenue tariff and 20% to pressure China to curb the supply of fentanyl ingredients to third parties in Mexico or Canada. It is this fentanyl which fuels the US drug crisis. This is a priority for the Trump administration.
How Import Tariffs Affect US Inflation.
We can calculate how much inflation a tariff adds to the US economy in the same way as Scott Bessent by multiplying the effective tariff rate by the proportion that imports are of US GDP. Based on a 20.5% US effective tariff rate, I calculated that it adds 3.28% to the US headline Consumer Price Index (CPI). This results in a US headline inflation rate of 6.1% for the year ahead. In Australia, we can draw parallels to the 10% GST introduced 24 years ago, where price effects were transient and vanished after a year, avoiding sustained high inflation.
Before these negotiations, the US was levying a nominal tariff on China of 145%. Some items were not taxed, so meant that the effective tariff on China was 103%. Levying this tariff meant that the US faced a price effect of 3.28%, contributing to a 6.1% headline inflation rate.
If the nominal tariff rate dropped to 80%, the best-case scenario I considered previously, the price effect would fall to 2.4%, with a headline US inflation rate of 5.2%. With the US now charging China a 30% tariff, this adds only 2% to headline inflation, yielding a manageable 4.8% US inflation rate.
As Goolsbee indicated, the Fed might consider raising interest rates to counter inflation or cutting them to address reduced output, but ultimately, it is likely to maintain current rates, as it did last week. I anticipate the Fed will continue to hold interest rates steady but with an easing bias, potentially cutting rates in the second half of the year once the situation stabilises.
My current Fed Funds rate model suggests that, absent this year's tariff developments, the Fed would have cut rates by 50 basis points. This could be highly positive for the US economy.
