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Capital Economics says the resulting surge in US inflation from the announced tariffs is going to 'come faster and be larger than we initially expected'

Economy / analysis
Capital Economics says the resulting surge in US inflation from the announced tariffs is going to 'come faster and be larger than we initially expected'
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Source: 123rf.com

Independent global economics researcher Capital Economics (CE) says imposition of the Trump tariffs is going to result in a surge in US inflation that will come "even faster and be larger than we initially expected".

CE's chief North America economist Paul Ashworth says President Donald Trump’s decision to impose 25% tariffs on Canada and Mexico and an additional 10% tariff on China from this coming Tuesday, (with the only partial exemption for Canadian energy imports that will be subject to a lower 10% rate,) "is just the first strike in what could become a very destructive global trade war".

"Imports from the European Union will be hit within the next month or two and a universal tariff is coming in April. Since exports to the US account for around 20% of their GDP, today’s tariffs could plunge both the Canadian and Mexican economies into recession later this year. The resulting surge in US inflation from these tariffs and other futures measures is going to come even faster and be larger than we initially expected," Ashworth said.

"Under those circumstances, the window for the Fed [US Federal Reserve] to resume cutting interest rates at any point over the next 12 to 18 months just slammed shut."

Ashworth said ostensibly the tariffs are a means of applying pressure to stem the flow of fentanyl over the border but, since US seizures of the drug on the northern border amounted to a trivial 43lbs in the whole of last year, "it’s clear this is just a pretext for Trump to employ the International Emergency Economic Powers Act for the first time to levy tariffs".

"We don’t expect any deal that sees these tariffs removed any time soon, although it’s possible that more sectors could be added to the exemption. For a start, even domestic automotive sector costs will soar given that parts can cross the borders several times during the production process."

Ashworth said factoring in the imminent tariffs to be imposed on the EU and the universal tariff soon, "we suspect that US inflation will climb back above 3% later this year".

"Admittedly, since the new tariffs represent a one-off increase to the price level rather than an ongoing increase in the rate of inflation, at least as long as second-round effects are limited and inflation expectations remain well anchored, then the Fed doesn’t need to over-react," he said.

"Nevertheless, any chance of more interest rate cuts this year just died."

Ashworth said Canada (US$419bn), China (US$427bn) and Mexico (US$475bn) together account for 43% or US$1.3trn of the US$3.1trn value of goods imported into the US in 2023. Imports from Canada includes US$124bn of energy & minerals.

"The upshot is that this tariff announcement alone is already roughly three to four times the size of the original 25% imposed on slightly less than half of imports from China in 2018 and 2019."

Revenues from the tariffs could reach almost US$250bn per year, or 0.8% of GDP, Ashworth estimates.

"That could be a significant hit to the US economy if those revenues are used to reduce the federal budget deficit rather than recycling them into the economy by cutting taxes or boosting federal spending. US exporters will also lose out thanks to the stronger dollar, but retaliation by the other countries is likely to be modest, at least initially, as they seek to avoid inflaming tensions."

Snce goods exports to the US account for close to 20% of their GDP, the 25% tariffs represent an existential threat for both Canada and Mexico. But as China’s exports to the US account for less than 3% of its GDP now, an additional 10% tariff won’t have much of an effect on its economy, Ashworth said.

"Even allowing for a further depreciation in the Canadian dollar, we estimate that the 25% tariff on Canada will hit exports, investment and consumption, resulting in a 2.5% to 3.0% decline in GDP. The public finances are in good shape, however and the Bank of Canada has scope to cut interest rates by at least another 50bp. The upshot is that strong fiscal and monetary stimulus should limit the severity of any recession," he said.

"For Mexico, we suspect that the inflation generated by a weaker peso will prevent Banxico from cutting interest rates further, while fiscal policy needs to be tightened. As a result, even though we expect the hit to Mexican GDP to be closer to 2.0%, there is little scope to offset the tariff impact by loosening policy."

Ashworth said that Trump’s determination to force through substantial tariffs on supposed allies less than two weeks after taking office, and despite the opposition of some moderates within his administration, is "a clear indication that the gloves are off this time".

"In recent days Trump has also talked repeatedly about imposing substantial tariffs on the European Union and a growing list of products like steel and pharmaceutical products. His pick for Commerce Secretary, Howard Lutnick, also warned in his confirmation hearing last week that the European Union would be hit and that a universal tariff was coming as soon as April. How far this goes now is anyone’s guess. But the effective tariff rate on all US imports is already now up to around 10%, for the first time in more than 75 years, with plenty more to come," Ashworth said.

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65 Comments

Tarrifs are deflationary

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Legitimately curious, what's you basis behind that?

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An argument can be made that tariffs are essentially an added tax on consumers. Taxes remove money from circulation, and higher taxes/trade wars usually constrict economic activity, which counteracts inflation. Yes the basket of goods measured in data like CPI may shift higher in the short-term, but ultimately customer's willingness/ability to pay for goods is the main driver of price activity. What's happening in the USA is a little more nuanced than "Trump tarrifs = inflation". In the medium/long term I don't believe Trump tarrifs would be neither inflationary or deflationary, as selective (& non-selective) tax policies in isolation, aren't major drivers to pricing. 

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 Taxes remove money from circulation

doesn't this depending on how tax being used?

tax is just means part of the output of an economy falls in control to the government rather than private sector.

 

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Technically yes. However that would still indicate a neutral effect at best. If Trump takes more money from consumers through tarrifs, then dishes that money back out again in tax cuts, we're left with a net 0 change in purchasing power. Of course that's an oversimplification, but the general idea is tax regimes just aren't that significant in regards to cost/inflation. Tarrifs have happened in the past and will continue to happen with policy changes in the future, not once have they single-handedly caused an economic meltdown like people are currently anticipating with Trump.  

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GST hike we had here was inflationary. As it was a generalised tax on all goods, rather than a targeted tax on specific goods like most tariffs, it provided cover for vendors to engage in net inflationary pricing. MMT is a joke when it comes to the human behaviour side of economics. You can see examples of this from Trumps last trade war where US local manufacturers of washing machines raised their prices to meet the new pricing level set by the tariffs, BUT ALSO raised the prices on dryers, which were exempt from the trade war tariffs. The result was net inflationary action. Additionally, due to the loss of exports for US farmers who then begged and received welfare from the state as a result, accounted for a significant reduction in the net tax income. In MMT fairytale land you might say that it induced additional government spending causing a rise in the money supply.

The Smoot-Hawley tariffs definitely added to the carnage of, and possible extended, the Great Depression too. A depression is the primary fear that those afraid of Trump tariffs have as they see the conditions are right for a significant economic contraction.

Hell even on a first principals look broad spectrum tariffs lead to an inefficient economy, they intrinsically reduced economies of scale, undermining comparative advantage, and entirely ignore absolute advantages.

Add to that a significant decrease in the working population through a mass deportation program, and an economic downturn must be the default case.

SKF.

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It also depends on the ability to substitute products, can people simply switch to buying American made rather than imported products? eg US oil companies crank up their output and reduce Canadian imports.   

Currency markets are also having an impact, the rising US dollar is making all imports cheaper (if priced in non US$) so the tariffs are being levied on lower cost goods.  Alternatively buyers of products priced in US$ can ask for a discount from sellers benefitting from excess profits due to the exchange rate. The crashing NZ$ not so good for NZ consumers though!

Lastly, shipping may simply be rerouted - products from Mexico/Canada go to other export markets, products manufactured elsewhere go to the USA. eg. Fisher & Paykel supply the US from its NZ factory, and the rest of the world from its Mexico factory.  

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Deflationary for assets sensitive to interest rates, like stocks, bonds, and real estate, but inflationary for goods and commodities.

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^ This one

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Well we basically follow the FED so there goes the RBNZ Feb 50bps cut. Its going to be a hold.

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Hold or 25bps at best if Orr knows what he is doing. Close to 50bps is already priced in and with this possibly being an end to the cuts  this will send some psychological shocks through the market, particularly housing.

I'd be dumping real-estate and stocks right now.

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If Orr holds, market sentiment will change.

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If Orr holds and removes prospects of further cuts the housing market may actually crater this year. There is nothing left to support it.

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While I think the ass falling out of the property market is best long-run thing that could happen to this country, I am concerned about what increasing unemployment and possibly sliding inflation could do to the economy. Property euphoria is the only game in town unfortunately, and it's concerning we have nothing to fall back on.

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Yes Minister

I suggest that you know where the exit is relative to your seat, and that you brace for impact.

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Gentlemen, assume the position.

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You probably mean that half-heartedly-seriously, but I'd argue that a relatively flat property market is a better long-run outcome simply because it wouldn't bankrupt a generation of not just investors, but OOs that bought in recent years. We now have government trying to pitch a flat market, because it's an improvement from a tanking one. If political will for massive capital gains is lost on all sides of the aisle, they won't happen. They are not created by "the market", they are created through intentional planning restrictions.

If however we saw values do more than wipe 20% off 2021 highs, more than just deposits would be lost and foreclosures would be riskier for everyone and "the system".

Ultimately people near retirement are best left in possession of their "assets" too, lest we seriously upset their financial planning and end up needing to prop them up even more into the future with taxpayer funds.

Keeping values flat has the correct outcome of gradually changing behaviours (incentive removed) and increasing home ownership over time as incomes catch up, while not destroying anyone's lives (unless they're unwilling or unable to pivot away from being totally reliant on property gains).

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A lot of reasonable points in there, but it really drives home how much housing has become a welfare scheme in NZ (largely for those of us already possessing it) - especially when we also factor in the cost to taxpayers of stimulus, subsidies, and bailouts. We don't allow a free market with downward price discovery because this would be bad, might deprive old people of some of their wealth, see people lose their investments etc.

We should remember this every time some womble on here starts their ranting about school lunches and paying for other people's children, especially given school lunch programs have very high ROI in wealthy countries.

When we pour so much effort into propping up wealth and preventing loss of it, we really need to factor that into our understanding of Welfare and our discussions of the same.

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I think he goes the 50, its priced in and the NZ economy is on its knees, I do not see the NZ Banks passing on much of it, they are competing hard and have already lowered rates.    It maybe the last cut for a bit

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If the NZ2Y is a rough indicator of how much the RBNZ can cut, they could cut 50bps, but later be forced to hike if the NZD takes a hit or if the NZ2Y yield begins to climb due to uncertainty. 

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NZD down to 0.557 at the moment. Bit of a fall for the day. 

 

Edit: Now under 0.553

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It’s the USD strengthening, DXY is up about 1% to around 109. So it’s not just the NZD weakening. The market’s already priced in a 50bps cut to the OCR for the NZD. If the OCR stays where it is, NZD probably strengthens. Would take a deeper cut than 50bps or a tariff on NZ to weaken more than what’s priced in. But our economy’s struggling, so NZD is gradually dropping from that. We don’t have a safe-haven currency, during a global recession, we’ll weaken against the USD.

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Let's see in just over two weeks. A week is a long time in politics

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Disagree. I think 25 or 50, and I think 50 is still the likeliest

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RBNZ will cut and keep cutting. NZD will be sacrificed. RBNZ built a forex war chest last year so they can try and keep the decline orderly and make some profit on the way down. On the plus side NZ exports will get a boost from the lower dollar.

Also Canada is now looking for alternative global suppliers for what they purchase from USA. Vice versa for USA imports from Canada. 

Can we help with that?

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Sacrifice the poor to the property market! This is the way.

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Is a $18.5 billion dollar war chest going to be enough? It will help. Seems like the RBNZ saw this coming. 

From the internet:

Many countries maintain reserves worth at least 3-6 months of imports or 15-20% of GDP for stability. For New Zealand (GDP ≈ $250 billion USD), this would mean $40-50 billion USD in reserves for strong currency defense.

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A logical step would be to admit Canada into the CER agreement.

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Also Canada is now looking for alternative global suppliers for what they purchase from USA. Vice versa for USA imports from Canada. 

Given how they fought tooth and nail to try and keep our dairy out of their country, I wonder how they'll be thinking about that now?

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The RBNZ is going to cut by 0.5% in two weeks, there's no guessing, the man making this decision told us so (I did too).

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You sound worried about your guess Yvil... a lot riding on it I guess.

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Ok but then how long before he has to put it up again ? I suspect he may stop making all those long term calls that he then feels he needs to make good on. If it goes down 50bps this month and then up again a couple of months later, was it really a cut ?

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A counter view ...

Methinks central banks will choose to 'look through' price rises in goods subject to tariffs as they are clearly neither capacity nor wage related.

Once that period has passed, central banks could quite easily respond by dropping central bank rates to keep everything afloat. They might even do that earlier than many here are anticipating. (The HFL crowd are going to be pissed.)

But as always ... It depends on how long this nonsense persists.

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I doubt it. The narrative is that Trump wants lower rates, while Powell is ignoring him. Inflation is still a concern for Powell, so it’s very unlikely we’ll see a rate cut from the Fed in the first half of this year, and it’s becoming increasingly unlikely for the second half. I think we’re in a new era of mercantilism and protectionism.

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Have you seen what Trump does to people who believe in doing their job instead of what he asks? Lebryk is instructive.

Powell won't survive if Trump wants a cut and doesn't get one. We may be approaching the end of the era of central bank independence. Even Luxon a week ago was going "I know I can't tell RBNZ what to do but..."

There's now votes in manipulating monetary policy. Everything else be damned.

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Powell said he'll finish his term. Trump can't fire him, so he's got until May 2026. It's going to be entertaining to watch the drama unfold.

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Certainly is, especially if Powell is a Dem's supporter, he will have Trump shitting his pants.

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I agree Chris, its one of those dangerous periods for traders and central banks.

The Central Bankers have an underlying need to not let things collapse under there watch, but at the same time who would not take the opportunity to pass along a few price rises hidden within the effects of trumps Tariffs.  they need to be super careful to understand the nature of any price rises here.

At the same time the USA has a huge amount of treasuries rolling over...

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Great news for exporters. Could see .4 very soon.

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Why does he not just put tariffs on every country?

If not then there is less likelihood of bringing the industry back to US, they will just import from a tariff exempt nation (and manufacturing shifts there).

 

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Why does he not just put tariffs on every country?

Because he's a mental case who's decisions aren't guided by much more than whatever brainfart grabs his attention the most.

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"Imports from the European Union will be hit within the next month or two and a universal tariff is coming in April.

I have no idea but is the universal tariff going to be on all the other imports that aren't directly specified by country of origin? 

 

Edit: It may be the case,

Will Trump Impose More Tariffs?

Trump has suggested he wants to impose universal tariffs on other countries’ goods, though it’s still unclear when that could happen or what any broader tariffs could look like. “I have it in my mind what it’s going to be but I won’t be setting it yet, but it’ll be enough to protect our country,” Trump said Monday about his plan to impose tariffs on all imported goods. The president told reporters Friday he plans on “doing something substantial” in terms of taxing European imports specifically, saying, “Am I going to impose tariffs on the European Union? Do you want the truthful answer or should I give you a political answer? Absolutely, absolutely.”

https://www.forbes.com/sites/alisondurkee/2025/02/02/trump-tariffs-live…

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Trump likes Tariffs cause they are a big bargaining chip to extract what he wants from other countries - simple as that. 

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What does he actually want from Canada though. At no point has he actually clearly communicated what the end goal of these tariffs are or what Canada could do to prevent them.

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Yes he has, he wants them to be the 51st state!

If he has a 1% chance of getting that (maybe Poilievre will help?), he'll be in the history books forever. He'd love that. So it's worth it. If it fails, it was only Canada after all, he could be famous as the one that risked it all to try?

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He could get famous for becoming Adolf Trump.

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Anything's possible when he's in his last term and can't do anything to extend it. I suspect Trump doesn't really care what happens to "his" party after he's gone either. I suspect he's not even interested in grooming and puppeting a successor, because he wants the credit.

His final year could see a lot of fireworks.

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Will be interesting to see whether he pushes through with using GitMo as a concentration camp!

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To stop all the drugs coming across the border....(apparently) /sarc

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The precursor drugs for Fentanyl are legal in Canada, so drug traffickers have figured out that its easier to import the ingredients to Canada and make it there, then smuggle it across the Canadian border than it is to try and smuggle Fentanyl directly from China.

https://www.cbc.ca/news/politics/fentanyl-produced-in-canada-1.7275200

Both north and south borders need to be closed, and some action taken on Fentanyl production.  As Trump said, either he will do it but make them pay for it, or they can do it themselves. 

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Do you honestly believe that is the reason for these tariffs? It seems like a massively disproportionate response.

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Newsflash, the Mexican cartels always find a way, be it buy stealth or by force they will get their profit, and history shows that the demand is not slowing for their product.

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with the only partial exemption for Canadian energy imports that will be subject to a lower 10% rate

Canada has imposed a 10% export tax on oil. hence it'll be 20% tariff for US consumers.

 

Revenues from the tariffs could reach almost US$250bn per year, or 0.8% of GDP, Ashworth estimates.

"That could be a significant hit to the US economy if those revenues are used to reduce the federal budget deficit...

that 250bn is 0.69% of US Government debt.  if the tariff just canceled this years cut, it means all those extra tariff tax will be eating out with the extra debt interest payment. 

 

 

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In 2023, total U.S. de minimis imports were one billion parcels valued at about $54.5 billion. With the rise of Temu and other platforms, it was likely much larger in 2024. None of these shipments had duty paid in spite of the existing China Tariffs. Now they will pay 25% or more. Not to mention the extra time and expenses related to customs clearance which will affect overall delivery speed and customer experience. 

Companies may have to position inventory in bulk to a US warehouse and pay for fulfilment from there to US customers. 

Either way, it will be inflationary.

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I don't think a Temu glow in the dark pencil going from $1 to $1.50 is actually inflationary in the grand scheme of things. The only stuff that really matters (where margins are across the border) are energy imports, and maybe to an extent large manufacturing like fully assembled cars and machinery.

Stuff like booze is basically immune because it's already duty heavy. Canada's only playing with stuff there because it hits the right part of the US political motivation system.

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Canada is imposing 25% retaliatory tariffs on the USA, Canadian inflation is going to be increasing faster than American inflation.  They will not be able to cut rates.  

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Plus their currency is crashing.  Double whammy.  Going to be fun for the current Govt going in to the election.  #notwinning

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I actually think there’s a world where if Trump continues it could provide the patriotic spirit to back Trudeau into returning as party leader, from the sounds of everyone I know in Canada they are having a huge unity moment over Trumps economic warfare…

SKF

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Fighting every trade war at once is a bold move. Possibly too bold ultimately.

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Whether you like him or you lump him he plays to win. Exactly what winning is, however, is anyone's guess. He likes to play at home so he's wanting there to be a stream of world leaders flying into DC or Mar-al-Lago. I actually think he wants to reset the global agenda with him setting up the new rules. He's got the ego for it. He's got the energy for it [amazingly] & the big one is... he's got form. Welcome to the Trump Twenty-First Century.

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What are in now, Week Two of Trump?  And Panama folds.

https://www.foxnews.com/world/panama-pledges-end-key-canal-deal-china-w…

 

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Be very careful with your bias, the world has clearly had enough of being manipulated with the uniformed opinions of those in a position to force false information on others. Instead of referring to this as Trump imposing substantial tarriffs, how about calling it the Mexico/USA border situation. Is it that your writing lacks impact so you must jump on the anti-Trump train for a bit of drama?  How boring and unoriginal. News flash, another win for Trump, the Mexican President stepped up and has deployed 10,000 troops to govern the border and reduce the number of illegals and drugs coming into the U.S .A. Mexico will now have to play their part instead of taking the piss like they have for decades. How awesome to see a President with guts, a president who puts his country and its people first.  Yes, it’s another win for Trump and the U.S.A!  Get used to it !

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the Mexican President stepped up and has deployed 10,000 troops to govern the border and reduce the number of illegals and drugs coming into the U.S .A. Mexico will now have to play their part instead of taking the piss like they have for decades. How awesome to see a President with guts, a president who puts his country and its people first.

How many of those soldiers will have their families threatened, murdered if they don't do the cartels bidding to keep the drugs flowing through. I would say many, as the cartels are well financed, armed and don't have limits to the level of violence they will commit to get their profit. It'll be interestin to see this play out

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Mexico to provide 10,000 troops and target drug imports, while Trump US agreed to helping curb smuggling of high-caliber weapons into Mexico. There could be benefit for both countries,  but we will have to wait and see if this will have any affect on cartel business and power, and therefore on the lives of people affected by illegal drugs and weapons

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Less than 24 hours, but this hasn't aged well.

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