Again, tariffs and inflation

Trade Tracker #8

A recent piece in the Wall Street Journal, “Do Tariffs Cause Inflation? New Studies Offer Surprising Answer,” highlights two economic papers that have found tariffs usually have not led to higher inflation (or only slight pickups), likely because tariffs tend to hurt the economy and reduce demand. If you read my November newsletter, you would not be surprised by those studies. Unfortunately, this is another example of muddling what “basic economic principles” tell us about tariffs and inflation.

Today, I want to unpack that a bit more, especially as we await BLS’s release of the Consumer Price Index for the month of December on Tuesday, and US Import and Export Prices on Thursday. (And not to mention, a potential SCOTUS ruling on Wednesday!)

The key point is simple. Tariffs do not raise the price level or cause inflation on their own. They increase relative prices of tariffed goods, and they reduce real incomes, forcing the economy to adjust through lower wages and higher unemployment, or, if the Federal Reserve intervenes, a higher price level. A price level adjustment depends on monetary policy, not the tariff itself, but the adjustment channel does not change the primary effect of tariffs, which is a reduction in real, after-tax income.

Part of the disconnect may be that many commentators (and consumers) use the word “inflation” pretty loosely. If the price of shoes increases because of tariffs, many people would point to that and exclaim, “inflation is rising!” But that would be incorrect. All we are talking about is shoe prices—a relative price increase—not a persistent increase in the rate of price increases across the economy.

And when you have to pay more for tariffed shoes, you have less income left over to spend elsewhere. This translates to less spending and lower incomes in non-tariffed sectors and a shrinking economy.

Referring to any and every relative price increase as inflation is part of the problem. But there’s also a bigger problem of misunderstanding the mechanics at play.

A tariff is a type of excise tax. When the government imposes a tariff, it places a wedge between the prices consumers pay for a good or service and the prices that producers receive. That wedge occurs regardless of whether producers pass the tariff on to consumer prices or “eat the cost.” In both cases, the tariff reduces the amount of income available to compensate workers. So here we have a tax increase that could push up some consumer prices and will reduce income—not an inflationary situation.

But now comes the part where a price level adjustment may come into play. The reduction in income creates pressure for businesses to reduce the wages they pay their workers. That’s problematic because of what economists refer to as “downward nominal wage rigidity.” Simply put, people don’t really accept nominal pay cuts. Instead, firms have to adjust their compensation costs by laying off workers or reducing hiring.

If a tariff hike is large enough, it may create a large enough increase in unemployment that the Federal Reserve chooses to act. Instead of allowing the adjustment to the new tariff to occur solely through layoffs, the Fed could raise the price level, allowing wages to fall in real terms while nominal wages remain constant. This is what it means for the Fed to “accommodate” tariffs. Accommodation would result in a one-time increase in the price level.

Another key point is that the real burden to US households is largely the same no matter the adjustment channel: tariffs shrink real, after-tax income. If the Fed does not accommodate, nominal incomes fall while nominal prices remain fixed; or if the Fed accommodates, nominal incomes remain the same while nominal prices rise. In both cases, real incomes fall.

Over-emphasizing the potential impact of tariffs on the overall price-level misses this key point and distracts from the very real harm that tariffs have on the economy and on American households. So when Tuesday’s CPI report arrives, remember: tariffs will always reduce household income, but whether they affect the overall price level depends on the Fed.