Will tariffs lead to a recession?

Economic Impact Assessment by Paul Krugman

• Krugman characterizes the Trump administration's tariff moves as an "order of magnitude" larger shock than any U.S. trade policy in history, including the Smoot-Hawley Tariff Act of 1930.
• The current average tariff rate is projected to jump from approximately 3% to over 20%, a shift vastly larger than Smoot-Hawley's incremental increase on an already high base.
• Unlike traditional tariffs which generally raise costs without causing recessions, Krugman identifies "extreme uncertainty" as the primary driver of potential recessionary pressure.
• He argues that unpredictable policy shifts create a "real option value" for businesses to withhold investment, fearing stranded assets regardless of whether they invest domestically or abroad.
• Krugman suggests that policy reversals may exacerbate instability if those reversals themselves are subject to sudden reversal, rather than restoring long-term confidence.
• Regarding the recession's severity, Krugman forecasts a likely moderate downturn, as business investment in tradable sectors (roughly 25% of the economy) is expected to be the primary casualty.
• He notes that while consumer spending is largely non-tradable, a collapse in consumer confidence—already at record lows despite current economic resilience—could escalate the recession into a severe event.

Goldman Sachs Baseline Forecast by Jan Hatzius

• Goldman Sachs estimates a 16-percentage-point increase in average tariff rates, translating to a roughly 2-percentage-point hit to GDP growth for the year.
• The firm's baseline forecast for fourth-quarter-to-fourth-quarter growth is 0.5%, down from an initial expectation of approximately 2% prior to the tariff announcements.
• Hatzius assigns a 45% probability to a recession occurring; this probability rose to a majority "recession call" when full reciprocal tariffs were enacted, dropping back to 45% following the announced pause.
• The estimated growth hit is attributed to three specific components: a tax-like reduction in real income, tightening financial conditions, and reduced business investment due to uncertainty.
• Hatzius views a policy-induced recession as likely moderate and potentially reversible, noting that the Federal Reserve has significant policy space (federal funds rate at 4.25%–4.5%) compared to a liquidity trap scenario.
• He warns that the Fed may act too late due to the "stagnationary shock" dilemma, facing conflicting mandates to control rising inflation while combating falling growth.
• However, Hatzius asserts that if the labor market deteriorates significantly, the Fed would likely cut rates aggressively to prioritize maximum employment.

Long-Term Strategic Perspective by Oren Cass

• Cass argues that the tariffs are a necessary long-term adjustment to globalization and China's rise, accepting short-term costs to reestablish a link between corporate profits and domestic economic well-being.
• He contends that the policy substance alone is insufficient to cause a recession, predicting that investment in U.S.-based production will rise as a result of the "rewiring" of supply chains.
• Cass dismisses the uncertainty narrative as an excuse, citing historical precedents where corporations successfully invested in markets like China despite geopolitical risks.
• He acknowledges short-term costs, including reduced corporate profit expectations, but argues these reflect a correction away from the financialization that previously benefited multinational corporations without benefiting domestic workers.
• Cass anticipates that the administration will face frustration from allies and markets regarding the abruptness of changes but expects a course correction toward clearer long-term communication.

Forward-Looking Consensus and Risks

• A central disagreement exists between the guest economists: Krugman fears permanent damage from policy flip-flops, while Hatzius believes a policy pivot can stabilize the economy if recessionary data emerges, and Cass sees investment opportunities regardless of volatility.
• Goldman Sachs expects to gain clarity on the real economy's damage over the next two months, though immediate data lags and distortions may temporarily hinder assessment.
• The severity of the economic outcome hinges on the Fed's ability to navigate the trade-off between inflationary price levels caused by tariffs and deflationary pressures from reduced demand.
• Markets and investors remain focused on the potential for a "second-order effect" where consumer and business morale declines, even if immediate economic data remains robust.