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The writer is an external member of the Bank of England’s Monetary Policy Committee
For a small, open economy like the UK, the impact of US tariffs on inflation is somewhat ambiguous and influenced by a number of factors, including exchange rates. Economic theory suggests that unilateral US tariffs should push the US dollar up, with the exchange rate offsetting some of the impact of tariffs on other countries. But so far, the opposite has happened.
How central banks might respond to US tariffs when setting domestic monetary policy therefore depends partly on whether recent exchange rate moves reverse or persist.
Modelling the impact of US tariffs on the UK or global economy is fraught with uncertainty, particularly when the tariffs and countermeasures evolve rapidly. For the UK, other countries’ responses to US tariffs will also heavily influence the impact on growth and inflation.
There are various channels through which US tariffs are likely to propagate through the UK economy. Those placed on UK goods will raise their cost relative to US-produced substitutes. This is likely to sap demand for UK exports. Other tariffed countries would see demand for their goods fall as well, and the negative income shock would further weaken demand for UK goods. The bigger the trade distortions put in place, the bigger the global demand shock. Other things being equal, the result is likely to be weaker UK growth and inflation.
But other things may not be equal. As I laid out recently, if foreign producers are unable to sell as profitably to America, they might engage in trade diversion. They may lower their prices to gain access to alternative markets, reducing import costs for the UK and providing a disinflationary impulse.
The impact of trade diversion on output is less clear. Cheaper goods should boost UK real incomes and consumption. But they could also make it harder for domestically produced substitutes to compete, dragging on activity.
If tariffs result in supply chain disruptions, we might expect price spikes to cascade through production networks, pushing growth down and prices up. Trade fragmentation also reduces knowledge spillovers between countries and drags on competition. All else equal, this should reduce productivity growth and push inflation up.
These channels are likely to be directionally consistent whether there is retaliation for US tariffs or not. But economic theory would suggest this isn’t the case for exchange rates.
If the US imposes unilateral tariffs on other countries, then US demand for foreign currencies should fall and the dollar should appreciate. This would make the UK relatively more competitive while also raising UK import prices. This in turn would boost growth and inflation.
If widespread countermeasures are imposed on the US by other countries, then demand for US imports could fall, sending the dollar lower. The relative appreciation in sterling would drag on competitiveness and UK growth. The UK would also face lower import costs, tempering inflation.
That is the theory. But off the back of US President Donald Trump’s “liberation day”, the dollar has weakened. Amid high volatility following the April 2 announcements, the expected US Dollar Index (DXY) and actual DXY diverged significantly. Sterling has strengthened relative to the dollar, remaining above pre-liberation day levels.
The US is the UK’s largest single-country trading partner, but the EU is the UK’s largest trading partner overall. Moves in the euro therefore impact UK growth and inflation as well. Following the US tariff announcements, the euro has appreciated relative to sterling, offsetting some of the impact of dollar weakness in the sterling exchange rate index (ERI), the trade-weighted measure of sterling versus a basket of currencies.
If the dollar were to weaken further, the drag on UK growth and inflation would probably be larger. If the dollar rallies instead, the disinflationary impulse of tariffs on the UK would be relatively less significant.
It is too early to say what has driven foreign exchange developments and whether they are likely to reverse or persist. At a recent Treasury select committee hearing, chair Meg Hillier highlighted the use of “uncertain” in the Bank of England’s Monetary Policy Report had roughly doubled between last August and February. Given recent developments, that reference looks set to rise further.
