Yesterday, the Trump administration announced new tariffs of 25% on all imports from Mexico and Canada and 10% on all imports from China. In response to this announcement – which wasn’t entirely unexpected – US stocks fell and interest rates rose.

The simple interpretation is that higher import prices drive up US inflation, causing the Federal Reserve to raise the policy rate (pushing market rates up). This reduces economic activity (and therefore earnings in US companies, hence pushing stocks down).

While there’s certainly truth to this, it should be noted that firstly, an import tariff is a “one-off” increase in price level, and the resulting rise in inflation is only temporary – in a year, inflation will fall back (though the price level will remain higher). And the Fed shouldn’t really react to this.

The real story: America’s monetary superpower status at risk

However, in my view, there’s a more important mechanism at play that leads to PERMANENTLY higher rates if the tariffs are maintained. For decades, the US has enjoyed what’s known as an “exorbitant privilege” – a term coined by French finance minister Valéry Giscard d’Estaing in the 1960s when he was serving under President Charles de Gaulle.

He used this phrase to describe what he saw as America’s unfair advantage of having the dollar as the world’s reserve currency.

As American economist Barry Eichengreen later perfectly summarized: “It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries had to pony up $100 of actual goods in order to obtain one.”

This privilege has allowed the US to run persistent deficits in both its balance of payments and trade balance – importing more goods and services than it exports. The flip side of this is capital movements. The deficit means that the US has EXPORTED dollars (that’s what the deficit is paid with), and as the global reserve currency, these dollars are eagerly absorbed by foreign central banks and investors.

This “exorbitant privilege” means that China, for instance, has built up large foreign exchange reserves over the past 30 years.

These reserves are largely held in dollars – and dollar assets – such as US Treasury bonds and money market papers. This naturally means that the interest rate on these papers is LOWER than it would otherwise have been. Moreover, strong international demand for dollars means that the US can print more money without it becoming inflationary – essentially getting a “free lunch” from its reserve currency status.

Therefore, if Trump truly wants to significantly reduce the US balance of payments and trade deficit through increased tariffs, he may inadvertently kill this “exorbitant privilege.”

It will mean less EXPORT of dollars – and yes, this must, ceteris paribus, lead to higher US interest rates (both real and nominal) and increased inflationary pressure – not primarily due to higher import prices, but simply because there will be less global dollar demand (less money demand).

Crucially, these dynamics imply a higher so-called natural rate of interest. This means the Federal Reserve would HAVE to raise rates just to maintain a neutral monetary policy stance – regardless of any direct inflationary effects from the tariffs themselves. The alternative would be effectively running an expansionary monetary policy at a time when the economy’s natural interest rate has risen – a recipe for additional inflationary pressures.

All of this is probably too complicated for Donald Trump to understand, but markets can easily see it… and if Trump continues down this path, we might as well get used to falling stock prices and significantly higher interest rates as America’s “exorbitant privilege” begins to erode. And then it will suddenly be very, very hard to fund the US government budget deficit.

Note: Illustration created with fal.ai/FLUX.