In April, the United States made headlines by imposing sweeping tariffs that altered global trade dynamics.
At that time, analysts offered a range of estimates regarding the possible impacts on economic growth, ranging from modest to significant, reflecting the uncertainty surrounding the ultimate consequences of the trade shock.
Six months later, the growth downgrade stands at the more favorable modest end of expectations.
This shift has been attributed to several factors.
The United States has made strategic trade deals with various nations, providing multiple exemptions that have mitigated potential fallout.
Furthermore, most countries have opted against retaliation, maintaining a largely open trading system.
The private sector has also shown considerable adaptability, front-loading imports and swiftly re-routing supply chains to minimize disruptions.
Consequently, the anticipated impact of increased tariffs has, so far, been less severe than originally projected.
Current projections indicate global growth at 3.2 percent this year, with a slight decline to 3.1 percent expected next year—a cumulative downgrade of just 0.2 percentage points from forecasts made a year prior.
However, it is premature and incorrect to assert that the tariff-driven shock is without consequences for global growth.
Labeling the tariff effects as negligible overlooks the heightened statutory effective tariff rate in the United States and the continuing trade tensions, which remain unresolved.
Historical patterns suggest that the full implications of such shocks may unfold over an extended period.
Presently, the burden of tariffs appears to rest primarily on U.S. importers, with import prices (excluding tariffs) largely unchanged and only minimal retail price increases observed.
Nevertheless, U.S. businesses may ultimately transfer these increased costs to consumers, while potential permanent changes in trade patterns could lead to losses in global efficiency.
Compounding the effects of tariffs, other economic forces are concurrently influencing growth trajectories.
In the United States, stricter immigration policies are constricting the foreign-born labor supply, adding another layer of negative supply shock alongside tariff impacts.
This decrease in labor supply has, thus far, been balanced by a cooling demand for labor, which has stabilized unemployment.
Additionally, financial conditions have remained favorable, the dollar has weakened in the first half of the year, and a surge in artificial intelligence (AI) investments is stimulating economic activity.
These demand-side factors are counterbalancing the pressures stemming from negative supply shocks.
In nations heavily impacted by tariffs, various dynamics are assisting in softening the blow.
China, for instance, has been navigating through higher tariffs by leveraging a weaker real exchange rate, redirecting exports toward Asia and Europe, and instituting fiscal support measures.
In Europe, Germany’s fiscal expansion is providing a lift to economic growth within the euro area.
Meanwhile, emerging markets and developing economies have benefited from more lenient global financial conditions, partly attributable to the depreciation of the U.S. dollar, demonstrating notable resilience thanks to significant improvements in their policy frameworks.
Despite this resilience, the tariff shock is contributing to an overall dimming of already lackluster growth expectations.
A slowdown is anticipated in the second half of this year, with only a partial recovery expected in 2026.
Compared to forecasts from last October, inflation is projected to remain consistently higher than previously anticipated.
Even within the United States, economic growth is proving weaker and inflation levels higher than were predicted a year ago, characteristic of a negative supply shock.
Thus, while the first half of the year showed steady performance, the economic outlook remains fragile, with risks leaning towards the downside.
The most significant risk persists in the potential for increased tariffs resulting from unresolved trade tensions, which could further disrupt supply chains and reduce global output by 0.3 percent next year.
Additionally, four key downside risks warrant attention:
First, the surge in AI investment presents both promise and peril.
Much like the dot-com boom of the late 1990s, current enthusiasm around technology is driving investments and lifting stock valuations, which in turn boosts consumption through capital gains.
This trend may lead to higher real neutral interest rates.
However, should this exuberance falter, it could prompt a sharp market revaluation, adversely affecting wealth and consumption levels, which may have cascading effects throughout the financial system.
Second, China’s ongoing structural struggles present a troubling outlook.
The nation continues to grapple with instability in its property sector, which has not recovered since the bubble burst four years ago.
The risks to financial stability are growing, as real estate investment remains on the decline, leading to weak overall credit demand and a precarious position on the edge of a debt-deflation trap.
While manufacturing exports have temporarily supported growth, their sustainability is in question.
China’s pivot toward investing in newer sectors like electric vehicles and solar panels involves large-scale subsidies designed to bolster productivity.
However, such strategies may have resulted in a significant misallocation of resources, thereby stifling overall productivity gains.
While industrial policy can enhance production in targeted areas, it must be delicately managed to avoid fiscal burdens and hidden costs.
Third, fiscal pressures are mounting across many governments, including major advanced economies, resulting in limited progress toward rebuilding fiscal space.
Without prompt action, an environment of slower growth, increasing real interest rates, and elevated debt burdens, combined with new spending demands—such as those for defense and climate initiatives—will further tighten fiscal constraints.
Low-income countries are especially vulnerable, having suffered from the impacts of previous years’ shocks, leading to potential social unrest among unemployed youth due to reduced opportunities.
Lastly, the credibility of institutions is at risk amid escalating political pressure.
Central banks face increasing calls to ease monetary policy to support economic activity, even at the expense of maintaining price stability, a move that typically backfires.
While easing might briefly lower real interest rates, it ultimately fuels inflation and raises inflation expectations more than desirable.
Trust in central banks is vital for anchoring inflation expectations, particularly during economic shocks—evident during the recent cost-of-living crisis.
As institutional independence diminishes, the decades of credibility built over time may erode, jeopardizing macroeconomic and financial stability.
Amid the predominance of downside risks, there remain avenues for potential improvement in the economic outlook.
Achieving clarity in policy would notably bolster the global economy, with clearer bilateral and multilateral trade agreements capable of enhancing global output by 0.4 percent in the near term.
Restoring tariffs to the comparatively low levels seen before January 2025, based on these agreements, could yield even more substantial benefits—approximately 0.3 percent increase.
Beyond investment impacts, AI promises the potential for elevating total factor productivity.
Under cautious assumptions, the combined benefits of reduced uncertainty, lower tariffs, and advancements in AI could boost global output by around 1 percent in the short term.
These considerations highlight the importance of sound policies in fostering confidence and predictability to improve growth prospects.
On the trade policy front, objectives should focus on reducing uncertainty and establishing clear rules that reflect the evolving nature of trade dynamics while seeking to strengthen trade relations where possible.
The current trend, where most nations have opted against retaliatory measures and are actively pursuing improved trade agreements, offers a beacon of hope amid challenging circumstances.
Additionally, enhancing domestic policies is crucial in mitigating global imbalances.
Fiscal strategies should aim to alleviate vulnerabilities, albeit gradually and in a credible manner, while urgent action is required to prevent further delays.
Improving the efficiency of public spending is vital for encouraging private sector investments.
While fiscal policy should focus on stabilizing the economy, monetary policy must prioritize independence and transparency, with a primary aim of sustaining price stability.
Beyond immediate stability, increased investment in future growth is essential.
Governments should empower entrepreneurs to foster innovation and enhance productivity, essential for sustainable economic development.
The advancement of AI, when guided by appropriate safeguards, holds promise for elevating medium-term growth prospects.
Though sector-specific industrial policies may seem appealing to policymakers, investments in education, public research, infrastructure development, governance, financial stability, and judicious regulation that balances innovation with risk management offer a more prudent and sustainable approach.
In summary, a pragmatic and adaptive multilateral approach, fostering cooperation among nations, is crucial for navigating these challenges ahead.
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