Fed Misled by Tariff Beliefs
The Fed spent 2025 focused on the wrong issues.
Throughout the year, officials treated President Trump’s tariffs as a serious threat to inflation. They believed the supply shock could drive up prices and make it harder for central banks to manage inflation. When these tariffs were announced, the Fed reacted with alarm. Their instinct was to avoid cutting rates too quickly, stay cautious about potential tariff-related price hikes, and keep policies tight to curb any inflation spike.
During a late October press conference, Fed Chairman Jerome Powell noted, “Tariff increases are raising prices on some items, which is pushing overall inflation higher.” He described a scenario where the inflation impact might be brief and represent a one-time price adjustment. Yet, he acknowledged that the effects could stick around longer than expected, which is a risk that needs careful evaluation.
Back in July, he indicated that the Fed would hold off on rate cuts because of tariffs.
Powell stated, “We effectively paused on rate cuts when we considered the scale of the tariffs. Overall, inflation forecasts in the U.S. have risen significantly due to these tariffs.”
At first glance, this reasoning appeared sound. However, recent economic research suggests it may have been misguided.
Tariffs and Inflation
A detailed study from the Federal Reserve Bank of San Francisco reviewed 150 years of tariff policy. Conducted by economists Regis Barnichon and Aayush Singh, the research looks into whether tariffs in nations like the U.S., U.K., and France had significant inflationary effects, particularly during the Trump administration’s sharp import increases. The results clearly challenge the Fed’s stance: Inflation tends to decrease after tariffs are raised, while unemployment may rise, but not the other way around.
Historically, a significant tariff hike (about a 4 percentage point increase) was associated with a decrease in the inflation rate by 2 percentage points and an increase in the unemployment rate by 1 percentage point. The researchers admit they aren’t sure precisely how this occurs but liken it to a reduction in demand.
This runs counter to the Fed’s current narrative regarding 2025 tariffs.
To grasp the implications of this misreading, consider a fundamental principle: Misinterpretations of economic shocks lead to flawed policy responses. If you misjudge the signs, your actions will likely also miss the mark.
The Fed associated tariffs with inflation, causing them to be overly cautious about interest rate cuts. This hesitation delayed aggressive easing and led them to view signs of economic resilience as a reason to restrain actions. If tariffs genuinely spurred inflation, their caution would make sense. Maintain strong policies. Prevent wage-price escalations. Don’t ease up just because labor market signs suggest risks.
However, if the San Francisco Fed’s research holds water, tariffs actually drive the economy in the opposite direction. They could be disinflationary, weakening jobs while reducing prices, possibly due to weakened demand or a shift towards greater productivity. One could argue that tariffs essentially act like additional monetary tightening, which central banks should counteract through easing instead of maintaining tight policies.
In 2025, the Fed reacted to the tariff shock even as inflation was dwindling and unemployment was rising. Their response was to keep stricter policies, resulting in two opposing pressures—tariffs lowering jobs and prices, while the Fed simultaneously tightened policy, fearing inflation that wasn’t materializing.
The Fed’s conviction that tariffs generate inflation led them to disregard contradicting evidence. For instance, durable goods prices increased by just 1.8% year-over-year, which hardly suggests a severe inflation trend. Prices for significant home appliances remained below 1.6%. Apparel costs even went down by 0.1%, while new car prices rose by 1.2% and new truck prices by 0.7%. Despite this, the Fed concluded that the specter of tariff-induced inflation still loomed large.
Errors in Policy That Need Addressing
It doesn’t take a catastrophic viewpoint to recognize the misjudgment. Indeed, the Fed likely maintained higher interest rates longer than necessary. The labor market has cooled more than it should have, and the housing market has stalled because of elevated interest rates. Part of the disinflation seen in 2025 can be attributed not just to tariffs, but also to the Fed’s decision to view tariffs as an inflation factor, thus restricting rate cuts.
If the Fed correctly interpreted tariff increases as disinflationary shocks, the appropriate response to slight weaknesses in labor demand would have been to ease monetary policy more aggressively, not restrict it. The narrative would shift from “Tariffs warrant caution against rate cuts” to “Tariffs are effectively handling some of the Fed’s tightening for us, so we should ease our stance.”
Instead of asking, “How do we prevent inflation from spiking due to tariffs?” the Fed should now consider, “How can we leverage easy monetary policy to counter the disinflationary and job-reducing impacts of tariffs?”
Such differing inquiries would lead to fundamentally divergent policy strategies.
In practice, this implies that the Fed is more predisposed towards further significant interest rate cuts in 2025, focusing on the labor market impacts of tariff shocks and viewing the combination of tariffs and low rates as complementary rather than conflicting. Ideally, the Fed would become a collaborator in economic planning rather than a reluctant adversary.
The pressing question is whether Fed officials are prepared to reassess their positions or if they will repeat past mistakes.
