The ‘Phony War’: Tariffs as prelude to a US recession

The tariff war launched by US President Donald Trump has entered a phony war stage. But the next six months will reveal the true impact of a threatened trade war.

Expert comment Published 28 May 2025 Updated 6 June 2025 4 minute READ

Dame DeAnne Julius DCMG, CBE

Senior Adviser; Distinguished Fellow, Global Economy and Finance Programme

The 8-month period in 1939–40 after Hitler’s invasion of Poland but before major Nazi attacks on the Allies was called the ‘phony war’.

It was a time of high uncertainty but relative calm, with a hope in some quarters that the worst risks had been avoided. Today, the pace of the tariff war launched by US President Donald Trump on ‘Liberation Day’ seems to be following the same trajectory. The reaction of ‘shock and awe’ at the pace of action during Trump’s first hundred days culminated with the 2 April announcement of ‘reciprocal tariffs’ imposed on friends and foes alike.

The president used executive orders as his legal tool, and Truth Social as his personal communications channel, to dominate the news and evade normal checks and balances.

Postponing the application of threatened tariffs is more of a ceasefire in Trump’s trade war, not a resolution.

His new tariff regime threw financial markets into a panic and threatened complex global supply chains. A tit-for-tat escalation of tariffs on China added fuel to the fire.

Then, within days, the phony war period began with the pausing of most threatened tariffs and the partial reductions negotiated with China. This buoyed the financial markets, reassuring some that the disruptions of President Trump’s first hundred days were part of a strategy that would settle into a pattern of more deals and less economic damage.

The partial trade deal with the UK was reassuring, while the latest skirmish between the US and the EU keeps suspense high. But postponing the application of threatened tariffs is more of a ceasefire in Trump’s trade war, not a resolution. Much less a surrender.

Positive signs, but backward looking

Recent data provide some superficial reasons to be positive about the health of the US economy.

US corporate earnings in the first quarter came in mostly on track. Share prices of big tech companies have regained much of the value they had lost in the wake of Liberation Day. US inflation fell slightly in April to an annual rate of 2.3 per cent, showing little sign of impact from tariffs. Even the unwelcome surprise of the 0.3 per cent fall in first quarter GDP (on an annual basis) was partly explained by a surge in imports as US companies built up their inventories to prepare for the tariff threat.

All of this data, of course, is backward looking. There are early indications, and strong reasons to believe, that the real damage is yet to come and that the US is entering a period of stagflation that will lead to a recession by the end of this year.

Inflation prospects

First, consider inflation. While in May the Consumer Price Index (CPI) fell slightly compared to a year ago, it ticked up slightly in April compared to a month ago. That was a reversal in  the first monthly reading after the Liberation Day announcements.

The widely watched survey of US consumer sentiment produced by the University of Michigan hit a near record low in May, sliding to 50.8 – just shy of the all-time low seen in June 2022. The survey pinpointed tariffs as leading to that decline in confidence, based on worries about a renewed surge of inflation.  The same survey of expected inflation 12 months ahead rose to an astonishing 7.3 per cent, up from 6.5 per cent expected in April. Were that to become reality it would be the US’s highest level since 1981.

Businesses too are concerned. The chief executive of Walmart has warned that ‘even at reduced levels, the higher tariffs will result in higher prices.’ The Yale Budget Lab estimates that the overall US effective tariff rate is now 17.8 per cent compared to 2.5 per cent when President Trump took office in January. There can be little doubt that such a jump in tariffs will spur a rise in inflation in the coming months.

A further risk will develop if the large tax cut  package under consideration by Congress results in a substantial rise in the government deficit, which is already running close to 7 per cent of GDP this year. Moody’s credit rating agency downgraded its AAA rating on US government debt in May. 

The labour market is tight, with unemployment hovering around 4 per cent.  Fiscal stimulus applied to an economy that is near full employment is a classic recipe for higher inflation.

While these risks remain, it is unlikely that the US Federal Reserve will be quick to cut interest rates. Indeed, in its May meeting, it voted to leave interest rates on hold, despite calls from President Trump to lower them.

Fed Chair Jerome Powell said ‘We can move quickly when that’s appropriate, but we think right now the appropriate thing to do is wait and see how things evolve.’ This is the prudent policy when there are two-sided risks in a stagflationary environment.

Growth prospects

Now consider the prospects for growth, where expectations and international repercussions are especially important. The drop in consumer confidence has been cited above.  Many large companies declined to provide sales or earnings forecasts with their Q1 results due to the uncertain environment. The chief executive of Maersk, the global shipping giant, warned that world trade volumes could contract by up to 4 per cent this year – compared to their previous projection of 4 per cent growth.

Exports account for 29 per cent of global GDP. A contraction in global trade would represent a global supply shock to growth, not only for the US but especially for trade-intensive countries and regions such as the EU.

The end of the ‘phony war’

As July approaches and the tariff ceasefires are due to end, this ‘phony war’ period will evolve into a spreading recognition of the real economic consequences of a trade war. Between now and then, the US may sign a few more deals.

But current negotiations with the EU have stalled, provoking new threats by the US and then an agreed deadline of 9 July for more negotiations. Even if a short-term EU–US deal can be agreed, it will still leave US tariffs on EU goods substantially higher than before.

These next six months will reveal the true impact of the threatened trade war.

Anxiety will build, stockpiles of imported goods will be running down, and businesses will see profits fall. Meanwhile, the US debt ceiling of $36 trillion is fast approaching and a Congressional agreement will be needed sometime between mid–July and early October if the US is to avoid default, according to the Bipartisan Policy Center. The usual brinkmanship will roil financial markets.

These next six months will reveal the true impact of the threatened trade war. Uncertainty will give way to damage limitation in the form of higher prices to reflect higher costs, lower consumer demand and postponed investment.  The likelihood of two or three more quarters of below zero growth in the US is high.

The irony is that as long as the US consumes more than it produces, higher US tariffs will do little to shrink the US trade deficit. But a tariff-induced recession in the US probably will.