S9 Ep50: Tariffs, Uncertainty, and the Exchange Rate

Episode Summary

Executive Summary: The episode examines why the dollar did not rise when U.S. tariffs increased, as textbook theory predicts. Monicelli and Merendino argue the key is structural trade policy uncertainty: when tariffs signal a durable shift in the trade regime, they can depreciate the dollar and weaken growth. Their evidence suggests tariffs are contractionary, often deflationary, and far more harmful when policy uncertainty is high.

Main Topics: Textbook tariff-exchange rate prediction: The hosts explain the standard theory that tariffs should reduce import demand, increase demand for domestic currency, and therefore appreciate the dollar in nominal and real terms. Why Liberation Day contradicted theory: The guests discuss the 2025 tariff shock and note that the dollar depreciated instead of appreciating, beginning well before Liberation Day because markets are forward-looking and had anticipated tariff policy. Structural trade policy uncertainty (STPU): The core concept is uncertainty about the persistence and regime of tariff policy, distinct from short-lived announcement noise. This uncertainty helps explain when tariffs move exchange rates in the opposite direction. Measuring uncertainty and identifying tariff shocks: The researchers describe an econometric approach that splits tariff series into sticky and volatile components, then uses the variance of the sticky component as a measure of STPU. Macroeconomic effects of tariffs: Beyond exchange rates, the paper finds tariffs generally reduce GDP, investment, and economic activity. Inflation effects are mixed initially but overall often turn deflationary through weaker demand. Policy credibility and framing: The discussion emphasizes that how tariffs are communicated matters: credible, transparent policy can reduce uncertainty, while noisy or inconsistent messaging raises it and worsens economic outcomes.

Key Arguments: The standard model predicts tariff hikes should appreciate the domestic currency because import demand falls and domestic currency demand rises. In 2025, the dollar depreciated after tariff escalation, showing the textbook prediction can fail when trade policy changes are interpreted as a regime shift. Exchange rates react in advance because they are forward-looking; tariff rhetoric during the campaign likely contributed to earlier dollar weakness. Structural trade policy uncertainty is different from temporary announcement noise; it captures uncertainty about whether the tariff regime will persist. High STPU reverses the usual tariff-exchange rate relationship: tariff shocks can depreciate the dollar instead of strengthening it. Tariffs are generally harmful to macroeconomic performance, lowering GDP, investment, industrial production, and often prices via weaker demand. Tariff effects depend on the policy environment; in stable regimes they may be more targeted, but under uncertainty they are broadly damaging. Clear, credible communication of trade policy matters because expectations about future tariffs shape current exchange rates and economic decisions.

Data Points: Tariff series sample period: 1990 to 2025 (through the quarter of Liberation Day) - Study period used for the tariff and exchange-rate analysis Structural trade policy uncertainty spike: All-time high in 2017 - Referenced around the U.S. withdrawal from the Trans-Pacific Partnership Tariff announcement example: 100% tariffs on China - Example of noisy, quickly reversed policy signaling under the second Trump administration Tariff proposal example: 25% tariff on everything - Trump campaign and policy rhetoric cited as expectations-shaping First observed dollar weakness: January 2025 - Dollar began sliding before Liberation Day in anticipation of tariffs Major tariff shock date: April 2025 - World trade order shocked by sweeping U.S. tariff increases Policy shock framing: Second Trump administration vs. first Trump administration - Authors argue the first period reflected a more fundamental uncertainty regime change

Pivotal Quotes: "The response of both the nominal and the real exchange rate to a tariff shock depends on the underlying state of the economy, which is pinned down by this structural trade policy uncertainty measure." — Tommaso Monicelli: Core finding of the paper on exchange-rate responses to tariffs "The textbook prediction is reversed in periods of high trade policy uncertainty." — Tommaso Monicelli: Summary of how tariff shocks behave when uncertainty is elevated "Tariffs that are imposed in a stable trade policy environment ... can act as surgical measures ... On the other hand, when tariffs are imposed under high uncertainty ... then these are definitely harmful." — Alfonso Merendino: Policy takeaway on the importance of the surrounding trade-policy environment

Implications: Policy makers should evaluate tariffs together with the uncertainty regime in which they are introduced. Credible, stable communication may limit damage, but tariffs launched amid high uncertainty are more likely to weaken the currency, reduce growth, and disrupt trade.