Tariff ‘stick’ to be followed by ‘fiscal’ carrot?

Posted 28 March 2025

As most of us are aware, markets have recently been taking one step forward, one step back and this week was no different. Equity markets started with a bit of positivity amid talk that Trump’s April 2nd tariff “Liberation Day” was going to be calibrated and phased. Trump’s unexpected announcement on Thursday of permanent 25% tariffs on autos together with threats of further tariffs should trading partners counter them with retaliatory measures, was directly at odds with the markets’ latest expectations, and so down things came.

For the Trump administration, tariffs are about trade, domestic jobs and tax revenue – although it is not yet clear whether one of the three aims dominates, which makes market’s assessment all the harder. While tariffs are all over the Friday’s news headlines on this side of the Atlantic, most US Americans are only marginally aware of the announcement.

On the Trump friendly Fox News’ website front page, there is no mention. CBS has the story as a second string, below further consequences of the remarkable inadvertent inclusion of a journalist in an uncontrolled smartphone chat amongst senior Trump administration officials.

Fox’s blanking of the trade story indicates that tariffs are perceived as raising consumer prices and remain generally unpopular. What’s getting more attention is the building of this administration’s first budget bill. US budgets are not a product of the executive’s wishes. In fact, the President’ does not directly have power to write it – the majority party in each chamber of Congress presents their own bills which are then passed and sent to the other for amendments, leading to a melding. Of course, the President has enormous influence but nothing can be passed without each chamber voting through the final bill.

The US legislature is in the relatively early stages of formulating the final bill, which must pass before September. However, the law requires that a bill be passed to continue spending and taxing in the interim. In addition, it’s now clear that the limit on the Federal government’s total outstanding debt (the infamous US debt ceiling) will be hit before September. The Congressional Budget Office noted this week that they expect the debt ceiling to be reached in August. After that “x-date”, no more spending will be allowed without off-setting revenues (and most revenues come around specific times in the year, which means overall spending will halt).

It is notable that President Trump has requested that the interim budget be passed with an amendment to increase the debt ceiling. Currently the amount of increase is not clear and many of the Republican fiscal hawks are unhappy – so much so that the Senate leader John Thune is scrambling to find enough votes; the nomination of Senator Stefanik to become the Ambassador to the UN has been rescinded as they need her vote. The Republicans may even need the votes of some Democrats.

The implication may be that the administration wants greater room to increase debt than many investors had thought; the current focus on spending cuts and tariff raising, which has been seen as a growth negative (the ‘sticks’), will be overtaken by larger than expected tax cuts (the ‘carrots’). US equities may have been supported at times this week by these thoughts.

However, throughout the week, US bond yields also rose and as we have pointed out many a time, that’s rarely helpful. Indeed, it may be that the administration has got itself into a bind where the prospect of tax cuts is seen as eroding fiscal soundness, inducing rises in yields which do more damage to growth than the help from tax cuts.

The tariff rises are likely to be sold to the public as a big payment from foreign companies into US government revenues, and so there is a rising danger that ‘Liberation Wednesday’ may see more unwelcome news for trade partners, alongside potential signals of greater than expected tax cuts to come. Whether the equity and bond markets would take this combination as good news is another matter.

For the UK and Rachel Reeves, there is a similar problem, albeit from a slightly different position. Trump has said he will cut taxes and Reeves has said she won’t raise them (at least in terms of headline rates). Just as in the US, investors appear sceptical that the Labour government will be able keep to its hawkish position on the government deficit if growth undershoots the Office for Budget Responsibility’s estimates.

Despite the Labour government doing as it said in the Spring Statement, it seems that investors take the view that “you did it this time, but what about the next?”. The issue is that the government’ has imposed upon itself a rule which means there is no effective buffer. It continues to maintain the same “headroom” which means that its policy becomes pro-cyclical. So, when the independent Office of Budget Responsibility (OBR) cuts nearer-term growth forecasts (as it has this time), the government finances worsen and the government has to cut expenditure given it has promised not to change tax rates or borrowing levels.

The OBR forecasts have deteriorated for this year, partly because of external events and partly due to the oddities in productivity (in which the revisions may well be wrong). .

However, Rachel Reeves was happy that the OBR viewed the Labour policies as enhancing medium-term growth prospects. As Paul Johnson of the IFS said, “planning reforms are judged by the OBR to boost the economy, and the government deserves credit for protecting investment spending in tough fiscal conditions” (and he welcomes Liz Kendall’s proposals reforming disability payments announced last week, while being disgruntled with Reeves subsequent fiddling with the details).

Despite sticking to her rules this time, gilt yields were near unchanged on the day and have risen since then, possibly because they tend to track the rise in US yields perhaps more than UK fiscal policy. Reeves must have hoped that keeping her word would bolster her fiscal credibility and the gilt risk premium would fall. No such luck.

The issue is that some (possibly many) investors believe that the UK economy is beyond remedy without dramatic action to cut expenditure so, inevitably, no amount of policy initiative of the size or scope of this government is likely to be enough. They believe the government will cave into debt expansion, much like some investors seem to think will happen in the US.

To build fiscal credibility, the Chancellor needs to get through the probable slowdown in the rest of 2025 while displaying further fiscal hawkishness. She is likely to get a soft patch after the higher payments for national insurance hit employers imminently, coupled with the tightening from higher bond yields and squeezed European manufacturers.

She and we must hope for productivity to pick up as the OBR projects and for the Global economy to show resilience to trade wars. At that point, the headroom will start to expand beyond the measly £9.9bn. In the meantime, we will hope that inflation starts to track lower after the summer. Ultimately, credibility will come from the long haul, which might feel more like an eon.

Next week marks the end of a quarter which always prompts some institutional portfolio rebalancing, and against the recent market movements would point to selling bonds and buying back of equity allocations. A new month also brings a lot of important economic data such as US payrolls, but Trump has (yet again) managed to create the prospect of another climactic week with his 2nd April tariff announcement climax. It takes a brave observer to say they know how it will pan out, the rest of us expect much of the same as the past two weeks: stop and start market action and quite possibly not significantly more policy clarity at the end of it.