Implications of higher US tariffs for the UK economy

Since Trump’s victory in the 2024 US presidential election, discussions around tariffs and their potential impacts have intensified. Some economists argue that tariffs could help reduce the US trade deficit and support domestic production by shifting income from consumers to producers. However, critics, including NIESR, highlight the broader, second-round effects that tariffs may trigger through exchange rates, inflation and interest rates.

The specifics of Trump’s tariff policies remain uncertain, with proposals ranging from 25 per cent tariffs on goods from neighbours like Mexico and Canada to 100 per cent tariffs on imports from BRICS countries. While the details are still unfolding, understanding the macroeconomic mechanisms at play is essential for interpreting their potential consequences. Our recent report on the global macroeconomic implications of higher US tariffs examines these secondary channels in depth. While that report focuses on the effects on both the US and global economies, this briefing will narrow its scope to explore the potential impact on the UK Economy.

Trade between the UK and the US

The United Kingdom runs a trade deficit in goods and services with the United States. As shown in figure 1, this deficit is driven by trade in goods, where the UK faces a shortfall of approximately £190 billion, while maintaining a surplus of around £170 billion in services trade in 2023. Historically, the trade balance has been in deficit, with the exception of 2020, when pandemic-related disruptions led to a sharp decline in goods trade, while services trade remained relatively resilient.

Figure 1 also shows that nearly two-thirds of total UK exports to the United States consist of services, which may not be affected by the possible rise in tariffs in the United States. So, which goods might be impacted by such tariffs? Figure 2 provides a breakdown of the top UK goods exports to the United States in recent years. Boilers and machinery consistently top the list, followed by vehicles and pharmaceuticals. Other key export sectors include optics, medical equipment, and organic chemicals. These sectors are more likely to face challenges from a rise in “blanket” tariffs.

Figure 1

A more detailed sectoral analysis by the Centre for Inclusive Trade Policy suggests that industries such as fishing, petroleum, mining and pharmaceuticals may be particularly vulnerable to tariff changes. Some minor gains from trade diversion are possible in sectors like textiles, but overall, UK exports could decline by as much as £22 billion. Another report by the Grantham Research Institute estimates that the value added of transport equipment in the UK could fall by approximately 3 per cent, with only a limited total impact on the broader economy.

While these studies provide valuable insights into the direct sectoral impacts, they only focus on direct trade impacts of a 10 per cent rise in tariffs against the United Kingdom. A more comprehensive approach, as highlighted in NIESR’s recent report, is needed to capture the full range of macroeconomic effects, including global price increases, exchange rate fluctuations, inflation dynamics and interest rates.

Exchange rates, import prices and inflation

Figure 3

This higher level of import prices would contribute to elevated domestic inflation, compounded by second-round inflationary effects. Imports of goods and services directly account for about a third of the UK’s GDP, implying a potentially significant pass-through effect between import and domestic prices. Some studies, including a recent comprehensive analysis by NIESR Fellow Paul Mortimer-Lee, estimate a lower price increase of 1.25 to 2 per cent for the United States, considering the share of imported goods in GDP. However, import prices are not the sole driver of domestic inflation as there will be indirect effects.

Higher prices for imported goods are also likely to push up the prices of domestic substitutes of these products. Additionally, as these tariffs are expected to be implemented as a “blanket tariff”, they are also likely to increase the cost of raw materials and intermediate goods. There may also be a knock-on effect from higher costs of intermediate inputs, especially where the United States is positioned in the middle of supply chains. For instance, if Chinese chips become more expensive due to tariffs, the price of US circuits used in cars manufactured in the United Kingdom would also rise.

Finally, higher expected future inflation could prompt workers to demand higher wages, which would further raise production costs for businesses, potentially feeding into consumer prices. Our model results indicate an up to 4 per cent increase in nominal wages and a 3.5 per cent rise in unit total costs in the United Kingdom over three years. As a result, we estimate that US import tariffs could add around 3 percentage points to UK consumer price inflation (figure 5).

Figure 5

The impact on UK GDP

Such an inflationary shock would undoubtedly necessitate a response from the Bank of England. Our findings suggest an increase in interest rates of between 3 and 4 percentage points, depending on tariff assumptions. The resulting higher cost of capital, combined with rising intermediate import prices and potential supply chain disruptions, would dampen investment. Higher prices would also curb domestic consumption and cause a fall in exports, leading to a combined negative effect on UK GDP. It should also be noted that higher import prices act as a negative “supply shock”, leading to lower output and higher prices. Our estimates show that UK GDP could be up to 2.5 per cent lower after three years due to the higher US tariffs (figure 6).

Figure 6

Policy options for the United Kingdom

To mitigate the negative effects of tariffs, the UK government could explore securing a trade deal with the United States. This could involve negotiating exemptions for strategically important manufacturing industries, introducing targeted protective measures and leveraging the United Kingdom’s comparative advantage in services trade.

Additionally, the United Kingdom could focus on strengthening and deepening trade ties with other key trade partners, starting with the European Union. Brexit has already had a significant impact on the UK economy due to reduced trade, foreign direct investment, and productivity, driven by higher non-tariff barriers and border controls. Revisiting trade policies to foster greater cooperation and reduce non-tariff barriers with the European Union could help offset some of these losses.

Finally, while tariffs primarily affect the demand side of the economy (by hitting consumption and investment), their impact on the supply side, or “potential GDP,” is likely to be limited. Tariffs may constrain the capital stock over time due to lower investment, but other supply-side factors such as labour and total factor productivity would be less affected. The UK government could prioritise increasing the labour force participation. One way to do that is to reduce inactivity rates, which remain historically high levels, particularly due to long-term sickness. Similarly, structural reforms to enhance competition and innovation by streamlining regulations could bolster total factor productivity, leading to a higher potential economic growth.

This article, authored by Dr Ahmet Ihsan Kaya was originally published by the National Institute of Economic and Social Research and can be found HERE.