Bank of America: Beware! Behind the arithmetic of tariffs, the U.S. is facing greater stagflation pressure

According to the Zhitong Finance APP, Bank of America believes that if the tariffs announced on August 1 are implemented, there will be an increased risk of a larger and more persistent inflation shock, which could last until 2026, with core personal consumption expenditures peaking at around 3.5%. However, in this tough tariff scenario, Bank of America is more concerned about the risks of non-linear effects. Under some indicators, including the Michigan survey, inflation expectations have already deteriorated, and the significant cost-push shock may prompt more companies to raise prices. According to menu cost theory, more companies may find it optimal to pay the fixed costs of adjusting prices. Meanwhile, the impact of the shock on economic activity will be amplified, potentially leading to real stagflation.

On July 22, Bank of America released a research report indicating that the latest tariff announcement in the U.S. could raise the effective tax rate by about 5 percentage points. Based on the composition of imports over the past 12 months, Bank of America estimates that the effective tax rate will rise to nearly 16% (Chart 1).

Although Bank of America's structural view remains unchanged, the latest developments pose an upside risk to its baseline scenario (which assumes that the effective tariff will stabilize around 10%). In particular, there may be more tariffs targeting specific industries. The uncertainty and duration of the tariff shock are extending. Even with Trump put options, tariffs may not fully return to the low points of May in the U.S.-China agreement.

An effective tariff rate increase of about 5 percentage points would reduce the U.S. fiscal deficit by about 50 basis points, which is not much for a deficit still above 6% of GDP, and it would bring about 30 basis points of upside risk to inflation and downside risk to growth.

However, the latest tariff announcement is far from a done deal. Instead, the extension of the deadline from July 9 to August 1 indicates that there is still room for negotiation. Nevertheless, as the stagflation shock may extend to 2026, the Federal Reserve is more likely to remain on hold, which aligns with Bank of America's unique view, that the Federal Reserve will not cut interest rates this year.

As of May, Bank of America's estimate of effective tariffs was very close to the actual tariffs imposed, with an overall effective tariff rate of 9.6%.

However, Bank of America has identified some discrepancies. Tariffs imposed on China in May exceeded Bank of America's estimates, with the actual calculated tariff close to 46%, while Bank of America's calculation was 38%. In contrast, tariffs imposed on Canada and Mexico were lower than Bank of America's estimates, although Bank of America's own estimates were already at a low level.

Chart 1: If further tariffs on specific industries are introduced, the effective tariff in the U.S. could rise to 16% or higher. After reaching a low of 11% following the U.S.-China truce, President Trump's tariff threats are heating up again (percentage points)

Note: The 90-day suspension period includes exemptions for electronic products. The U.S.-China truce includes the UK agreement. The latest situation and copper include the Vietnam and Indonesia agreements. Pharmaceuticals and semiconductors show the estimated impact of hypothetical tariffs on five specific industries 1. The Upside Risks of Bank of America's Tariff Benchmark Scenario

As the 90-day pause period is about to expire, President Trump has initiated another round of escalation in the trade war. President Trump announced an increase in tariffs on 25 trading partners starting August 1, raising concerns about higher inflation risks and downward growth risks. These letters include all major exporting countries to the U.S., such as the European Union, Japan, South Korea, Canada, and Mexico, as well as 20 other countries.

The government also announced a 50% tariff on copper imports and subsequently announced an agreement with Indonesia. Overall, the latest tariff announcement will raise the effective tariff rate in the U.S. by nearly 5 percentage points to around 16% (Chart 2). Additionally, President Trump hinted at imposing comprehensive tariffs of 15-20% on pharmaceuticals and semiconductors, which adds further upside risks to Bank of America's estimates.

2. Market Complacency Increases Risks

Despite Bank of America holding some optimistic views based on previous developments, including the 90-day pause, the U.S.-China agreement, and the U.S.-Vietnam agreement (see "The Great and Beautiful Agreement" and the (Not So) Good Agreement with Vietnam), Bank of America also believed that the passage of "A Great and Beautiful Bill" on July 4 could open the door for a re-escalation of tariffs before the July 9 deadline.

Bank of America believes that the passage of the fiscal bill provides the Trump administration with some buffer, allowing it to withstand another round of uncertainty brought about by re-escalating trade tensions with major trading partners. However, the market is exhibiting strong complacency, with stock markets and interest rates showing almost no reaction to tariff-related news. This may encourage the government to further escalate the trade war. However, if this occurs, once Trump's put options are ultimately triggered, some easing should re-emerge.

Bank of America's overall structural view remains unchanged, but the risk balance has slightly shifted towards a more hawkish tariff scenario. Bank of America still believes that the Trump administration will negotiate a comprehensive, country-specific agreement covering trade, immigration, defense, and energy, and if the market reacts strongly enough, Trump's put options will be triggered again.

However, Bank of America also believes that uncertainty shocks may last longer than initially expected. Even if a comprehensive trade agreement is reached, the nature of the agreements so far (maintaining benchmark tariffs of 10% or higher) poses upside risks to Bank of America's benchmark scenario that the effective tariffs in the U.S. will stabilize around 10%, a level close to the U.S.-China agreement, the 90-day pause, and the actual tariff revenue in May (Chart 2).

Chart 2: The Latest Tariff Escalation is a Blow to Trading Partners such as the EU, Japan, and South Korea - Contribution of U.S. Effective Tariffs Facing Major Trading Partners (%)

3. If Tariffs are Implemented on August 1, Stagflation Risks Will Be Amplified Any transmission of inflation is likely to take longer to manifest. Retailers are unlikely to raise prices on goods imported before the tariffs were implemented (which may also be why Bank of America has not yet seen the full impact of the April tariffs). They typically need several months to cycle through their inventory.

Bank of America believes that if the tariffs set for August 1 are implemented, it will increase the risk of a larger and more persistent inflation shock, which could last until 2026, with core personal consumption expenditures peaking around 3.5%. However, in this tough tariff scenario, Bank of America would be more concerned about the risks of non-linear effects.

Not only tariffs, but uncertainty itself also poses a downside risk to growth.

In terms of GDP growth, the latest tariff announcements have increased the risk of sustained uncertainty shocks, which could weaken the stimulative effect of the "Great and Beautiful Act" on capital expenditures. Even if the tariffs are not implemented, the situation may still be the same, as businesses may find it difficult to commit to projects when trade policies are in a state of constant flux.

Under some indicators, including the Michigan survey, inflation expectations have worsened, and significant cost-push shocks may also prompt more companies to raise prices. According to menu cost theory, more companies may find it optimal to incur the fixed costs of adjusting prices. Meanwhile, the impact of the shocks on economic activity will be amplified, potentially leading to real stagflation.

IV. Federal Reserve: More reason to be cautious about interest rate cuts

Bank of America believes that the latest round of tariff escalations could extend stagflation shocks into 2026, increasing the risk that the Federal Reserve will remain on hold. This aligns with Bank of America's distinct view that the Federal Reserve will not cut interest rates this year.

In fact, Chairman Powell has repeatedly stated that the Federal Reserve wants to have a clearer understanding of the impact of policy changes before taking the next step