Foreign tariffs weaken euro area economy, monetary policy can mitigate

Import tariffs imposed by other countries, such as the United States, can significantly impact the euro area economy.

The European Central Bank's analysis indicates that demand-side effects typically dominate, leading to lower euro area inflation and weaker economic activity over the medium term.

The study introduces a novel two-step approach to identify 'tariff-related trade surprises' (TTSs), which are unusual trade patterns linked to historical US tariff changes.

Researchers use a standard gravity model to estimate expected trade volumes, then isolate unexpected variations plausibly related to tariffs.

Findings show that TTSs, especially those cutting euro area exports to the US, lead to a decline in the euro area consumer price level by around 0.1% after 18 months, with industrial production following a similar declining pattern.

This overall effect resembles an adverse demand shock.

The impact of tariff-related trade surprises (TTSs) varies across industries.

Downstream sectors, producing final goods like machinery and autos, experience peak impact one to two years after a TTS, with output declining by about 0.3% and producer prices falling by 0.1% one year after a 1% fall in bilateral exports.

Upstream sectors, supplying intermediate inputs, may react more immediately.

Crucially, sectors hit hardest by TTSs are also the most responsive to interest rate changes.

This pattern, covering about 60% of studied sectors and half of euro area industrial output, suggests monetary policy remains a powerful tool to counter TTS-induced disinflation and cushion the drag from higher trade barriers.