When Tariff Inflation Was Lost, the Fed Invented a New Theory to Explain It

The most recent minutes from the Federal Reserve reveal more than just insights into financial policy; they provide a glimpse into the thinking of an institution grappling with its assertion that tariffs lead to inflation.

In June, Fed officials and staff continued to assert that tariffs on imports should, in theory, drive inflation. This belief seems almost etched in stone in the Eccles building, which was recently visited by President Trump. However, they observed some peculiar inconsistencies: inflation hasn’t been reacting as expected. Their explanation? They argue that prices are simply delayed because businesses are still moving through existing inventory that was bought at lower prices.

This notion might initially seem reasonable. Companies import, hold, and then sell products. If new items become pricier due to tariffs, it makes sense that the increased costs won’t hit consumers until old stock depletes. This theory sounds intuitive, yet it stands on shaky ground. Most of what we understand about retail pricing actually contradicts it.

Prices Don’t Wait for Old Stock to Run Out

The first flaw in this reasoning is something taught in reputable economics programs. Prices aren’t fixed by costs. Instead, they are determined by what consumers are willing to pay. If companies could charge more, they would already be doing so, regardless of whether tariffs are in play. As economist Ludwig von Mises argued, costs do not dictate prices; it’s the opposite. While tariffs can heighten input costs, they don’t guarantee a rise in prices. Companies might choose to tighten profit margins, scale back production, or drive some sellers out of the market. The Fed’s assumption that costs push prices upward starts to falter when we remember that ultimately, prices depend on demand.

Even within the framework of what is known as New Keynesian economics, which influences the Fed’s perspective, the idea that companies won’t raise prices until they sell off old stock simply doesn’t hold up. In a competitive environment, retailers don’t base their pricing on what they paid for inventory last month. They adjust prices according to what it will cost to replace that inventory the following month. Both models and real-life research, particularly during recent tariff-related events, demonstrate that price changes are forward-looking. Retailers tend to raise prices in anticipation of future costs, rather than clinging to past payments.

As for the “something else”? That’s about competitive pressure. Retailers aiming to keep their market share is another valid explanation. However, tariffs might not be as inflationary as once feared. This could suggest that inflation rates may not align with expectations, but the Fed seems to have conjured up a new inventory cycle theory to fill in the gaps.

This isn’t the first time the Fed has shifted its narrative to fit disappointing data. Previously, it attributed inflation to supply chain issues and then to labor shortages. Currently, it’s attributing it to depleting stock. A recurring theme here is the tendency to err on the side of questioning the underlying model assumptions instead of reevaluating the core beliefs.

If it turns out that tariffs haven’t actually led to the anticipated price increases, the issue might not be about timing. More likely, it lies in the flawed assumption that tariffs are inherently inflationary. Certain realities can’t be ignored—foreign exporters might absorb the costs, currency fluctuations could offset them, or they could simply get lost amid margin compressions and corporate pricing adjustments.

The Fed’s minutes suggest a lag in understanding the current reality. The risk in clinging to the idea of inflation delays is that it may blind them to the market’s clear message: tariffs are here, but inflation isn’t. Perhaps it’s time to rethink the theory and move beyond the perpetual cycle of excuses and forecasts.