Trump’s Tariff House of Cards Is Already Falling Apart

After the hardline rhetoric and sweeping tariff announcements of “Liberation Day,” the US administration is beginning to reveal just how weak a hand it has been playing. While officials are now trying to strike a more conciliatory tone—talking up the prospects of a deal with China and other trading partners—their counterparts are responding with marked restraint. China has a vague willingness to initiate discussions and has labelled talks of progress as “fake news.” Treasury Secretary Bessent’s comment that the China–US trade war is “unsustainable” is telling insofar as it reflects not strength, but rather damage control, with an administration increasingly nervous about the financial market volatility triggered by its own policies. Let’s take a closer look at how the US’s mad-scientist trade war experiment with China is backfiring.

To begin with, the most direct and visible channel through which the China–US trade war will disrupt the economy is inflation. Higher tariffs on Chinese goods will erode real disposable income and purchasing power for US households. China represents the largest source of foreign content in US personal consumption expenditures, making American consumers vulnerable, particularly lower-income households. The Tax Foundation’s estimate—accounting for subsequent exemptions on electronics granted by President Trump—puts the annual direct cost of these tariffs at just above US$1,200 per household.

While the impact on consumer durables should be felt quickly—the CEOs of Walmart and Target warned President Trump of empty shelves within weeks—the inflationary pressure extends to businesses’ inputs as well, which could show up later in consumer prices. Machinery, construction materials and industrial equipment are set to become more expensive, posing risks to capital expenditure plans and corporate margins.

This comes on top of other trade crackdowns, such as the 3,521% tariff the US announced this week on solar panels imported from East Asian countries—believed to be transshipment hubs for Chinese producers seeking to bypass trade restrictions. The resulting surge in costs threatens to delay solar energy deployments and undercut the investment momentum spurred by the Inflation Reduction Act. Expect less luck for that sector than for autos, for which the administration has signaled this week a “destacking” of tariffs on parts imported from China.

Second, China–US tariffs will likely distort incentives and encourage evasion. This outcome is part of the reasons tariffs are one of the few issues on which economists across the spectrum overwhelmingly agree. The sharp increase in exports from countries like Vietnam and Mexico—used as conduits for Chinese goods—was a direct consequence of earlier US tariffs. Customs fraud, transshipping and under-invoicing became common enough that US Customs and Border Protection had to scale up enforcement.

The broader risk is that firms begin allocating resources based not on productivity, but on tariff avoidance strategies. This results in higher costs, fragmented supply chains and inefficient capital allocation, dragging down long-term productivity. It also opens the door to illicit trade practices and undermines trust in trade rules—especially when those rules are applied in a quasi-arbitrary fashion, as seen with the “Liberation Day” tariffs. The result is a growing compliance burden for both firms and regulators that only compounds inefficiencies while delivering little benefit.

Third, the China–US tariffs may usher in a new wave of global supply chain disruptions. That’s because China is not just a major exporter of finished goods, but also a critical supplier of intermediate inputs and raw materials. One illustrative example is roofing membranes, the production of which is concentrated in a small number of Chinese factories. Pandemic-era lockdowns affecting those facilities led to significant delays and cost overruns in construction projects. In the context of what now resembles a quasi-embargo on Chinese imports, many more such stress points are likely to emerge.

Pharmaceuticals are one key area of concern: China supplies roughly 40% of the active pharmaceutical ingredients used in the United States. Other vulnerable sectors include electric vehicle batteries, defence-sensitive rare earth elements—where China controls about 70% of global output—and precision components in advanced manufacturing. These dependencies are difficult to unwind in the short term and could trigger widespread production bottlenecks.

Fourth, China holds meaningful economic leverage, which it is actively deploying in retaliation. In previous trade disputes, Beijing targeted politically sensitive US exports such as soybeans and pork—hitting agricultural states where economic pain quickly translates into political pressure. This time, the response is broader and more strategic, including the suspension of Boeing jet deliveries and sharp reductions in imports of crude oil and liquefied natural gas from the United States.

Non-tariff measures—delayed export licences, cybersecurity investigations, informal consumer boycotts—can be just as damaging as tariffs. For US multinationals with significant exposure to the Chinese market, either through revenue or supply chains, the cost of this retaliation (and the retaliatory measures from other countries) will accumulate quickly. The US International Trade Administration estimated that exports supported over 10 million American jobs in 2022—half of which were in manufacturing. One takeaway is that the US-initiated trade war undercuts the industrial revival the Trump administration is so eager to achieve.

Fifth, while the US–China conflict is bilateral in form, its economic consequences are global. Early estimates put the potential hit to global output in the US$1.5–2.0T range. Commodities are already reflecting the stress, with familiar bellwethers like oil and copper under pressure this month. But even more concerning is the dent in the US’s reputation as a safe haven. Bond yields have trended upwards while the US dollar faces depreciation pressures—a combination more commonly associated with countries grappling with balance of payments crises.

While China has so far refrained from directly weaponizing its position as the second-largest foreign holder of US Treasuries, the mere perception that Beijing could shift its reserves leaves investors on tenterhooks. Such a move, however subtle, could rattle the very foundations of the global financial system, where Treasuries serve as the ultimate risk-free asset.

That said, Beijing is likely to view this option as a last resort. It has every incentive to avoid actions that would undermine its own reserve holdings or trigger unintended financial contagion. For now, it may prefer more targeted, less self-damaging responses while allowing the economic damage from tariffs to play out.

But all of this puts the Federal Reserve in a remarkably precarious position. Already caught between an inflationary supply shock and weakening growth, it could find itself forced to respond to volatility in the Treasury market without seeming to compromise its independence or inviting moral hazard by giving the administration the impression that it can count on the Fed to fix its mistakes. As nerve-wracking as striking that balance may be, the Fed now also faces the added pressure of a president who, during the election campaign, openly expressed the view that the White House should have a say in monetary policy decisions and now seems to be looking into ways of making that a reality.

Speaking of election campaigns, we’ll be sharing our thoughts on the outcome of Monday’s election in a note next Tuesday, with a more comprehensive analysis in our pre-budget preview next month. After a dysfunctional period without a sitting Parliament and cycling through three finance ministers in just four months, a dose of stability won’t hurt. Attention will now shift to the long-overdue budget, which, unlike the costed platforms released this week, will need to incorporate more cautious economic assumptions.

Our updated forecast External link., released this morning, lands squarely between the Bank of Canada’s two scenarios presented last week. While the direct impact of tariffs on Canada is smaller, we expect the Canadian economy to be pulled down by the broader deterioration unfolding south of the border. When the neighbour’s house of cards comes crashing down, the dust doesn’t settle at the property line.