Following U.S. President Donald Trump's announcement of significant increases in tariffs, the U.S. economic policy uncertainty index has soared to a level that is higher than during the COVID-19 crisis. The index is constructed based on a textual analysis of newspaper articles. The index regarding trade policy alone has risen to an unprecedentedly high level not only in the United States but also in Japan.
When uncertainty rises, companies and households postpone investment and consumption decisions until the uncertainty subsides. As a result, uncertainty shocks can exert downward pressure on economic activities for more than a year. This effect is particularly strong for irreversible investment decisions that cannot be easily undone once initiated, as well as durable goods consumption decisions. Many global economic activities have such characteristics.
Imposing higher tariffs curbs trade. Furthermore, there is a great deal of uncertainty about whether a company's products will be covered by the Trump tariffs and what tariff rates will be imposed. The negative impacts on business activities are therefore amplified. Bilateral negotiations aimed at lowering tariffs could also increase uncertainty in the run-up to a final agreement, exacerbating wait-and-see behavior.
Countries' commitments to international trade rules, such as most-favored-nation treatments and the tariff concession system that promises not to impose tariffs above a certain level, limit uncertainty about the arbitrary imposition of high tariffs. Research on international economics have demonstrated that these rules have contributed to the expansion of international trade and foreign direct investment. The Trump tariff policy is an outrageous action that threatens to destroy the institutional infrastructure that the international community has developed.
With that in mind, a global economic slowdown will be inevitable for some time. In the United States, in particular, high tariffs are likely to have stagflation effects, whereby price hikes are combined with economic stagnation. The U.S. Federal Reserve Board decided to keep its policy interest rate unchanged at a recent Federal Open Market Committee meeting, explaining that the decision resulted from considering both economic deterioration and inflation risks amid high uncertainty about the economic outlook. This is because the interest rate adjustment policy alone cannot address both economic deterioration and price hikes.
When uncertainty is high, the wait-and-see mechanism also works for economic policy. Companies and households respond more weakly to policy, decreasing the effectiveness of macroeconomic policy. In fact, empirical studies have demonstrated that when the uncertainty index is high, the multiplier effect of fiscal policy is significantly reduced. The Trump administration seems to be planning to support the economy with fiscal policy that includes tax cuts; however, if uncertainty remains high, the effect of fiscal policy will diminish significantly.
In Japan, many political parties are advocating consumption tax cuts and cash stipend payments in the name of combating high prices and responding to the Trump tariff policy prior to a House of Councillors election. If there is a high degree of uncertainty, however, it is difficult to expect such policy measures to have a stimulating effect on the economy. If the policy objective is to supplement household income rather than create aggregate demand, it would be appropriate to focus on measures for households and workers who are severely affected. Finally, in the face of massive government debt, Japan should avoid repeating ineffective spending that would reduce its capacity to respond to potential uncertainty shocks, such as natural disasters, pandemics, and international armed conflicts.
>> Original text in Japanese
* Translated by RIETI.
May 30, 2024 - Published in Nihon Keizai Shimbun's "Economist 360° Perspective"
