Fed’s Milan Explains Misjudgments on Tariffs
Federal Reserve President Stephen Milan addressed the misconceptions surrounding tariff-induced inflation in a speech on Monday. His main point? Tariffs should only increase the consumer price level by about two-tenths of a percentage point. Even in a scenario of perfect pass-through, he estimates an upper limit of four-tenths and a near-zero lower bound if wholesalers opt to absorb the costs.
A crucial factor here is tax incidence, which refers to who bears the tax burden. It all hinges on flexibility. Those who can adjust—like shifting their buying or selling—manage to evade costs. Conversely, those who can’t adapt end up shouldering the burden.
Milan asserts that the U.S. is quite flexible. He emphasizes that U.S. buyers can easily switch suppliers, whether they’re located across the country or they turn to domestic options. On the flip side, foreign producers have invested time and resources into facilities that cater specifically to U.S. demand. As access to that market becomes pricier, alternatives become scarce.
“Given that we have the largest trade deficit, substitutes for U.S. demand are few, but many exist for supply,” Milan remarked.
Standard trading setups and numerous empirical pass-through analyses typically underscore the resilience of overseas supplies. Milan claims that this perspective, when adjusted for sunk investments, alters the reality of most traded goods.
Insight into Tariff Burden
Milan draws upon a 2018 study by economist Anson Soderberry published in the International Journal of Economics. This research tackles the vital question of estimating how responsive exporters are, without getting bogged down by assumptions that could skew the findings.
By examining variations in trade patterns, Soderberry seeks to estimate demand and supply reactions based on how similar exporters present products in various markets.
Using these estimates, Milan concludes that exporters will shoulder at least 70% of customs duties for about 70% of imported goods. For roughly half of those, they will bear at least 80% of the financial burden.
Why do exporters incur such heavy duties? The underlying reason involves the inflexibility tied to established investments. Once a manufacturer sets up a factory for the U.S. market, it’s not easy to uproot and repurpose. Workers develop specific skill sets, and the supply chain becomes more entrenched. Milan illustrates this point by saying, “Being a welder doesn’t make it easy to become a hairdresser.”
This reflects the broader theory that stationary resources tend to carry a heavier burden. Just as real estate often faces higher property taxes than mobile individuals, trade economics frequently assumes capital can be shifted with ease.
Milan points out the predicament of a Chinese exporter subject to U.S. tariffs. They might have invested billions into factories and supply chains geared towards American needs, and shifting to other markets is neither quick nor inexpensive. Contrarily, U.S. retailers can pivot to different suppliers with relative ease.
In such a scenario, exporters are inclined to reduce prices to stay afloat, meaning the burden remains with those unable to adjust.
Evidence Distortion
Research from the 2018-2019 trade conflict suggests that tariffs led to price hikes in the U.S. However, Milan argues that these findings may be skewed due to selection bias. The imposition of tariffs can alter observations about actual market behavior.
When tariffs are enforced, some exporters sidestep them by utilizing third-party countries or benefiting from exemptions for low-value shipments. Yet, these rerouting decisions aren’t random; they are motivated by financial incentives.
Milan’s stance is straightforward: exporters are more likely to reroute to avoid higher tariffs. This could create an unbalanced sample of transactions that skews data toward easier pass-through instances, leading to inflated averages.
He cites research from Jackson Mejia indicating that rerouting can fluctuate up to 40%, with some items seeing rerouted volumes hit 25%.
Milan also offers three checks against the notion of tariff-driven inflation. First, the timing doesn’t align. Core goods inflation began rising in mid-2024, before the tariffs took effect. Second, import-heavy core goods haven’t outpaced traditional products significantly since late last year. If tariffs were the driving factor, these categories should stand out, but they do not. Third, the rate of price increases in the U.S. doesn’t seem to deviate significantly from other countries like Canada or the UK, indicating that U.S. inflation isn’t particularly exceptional.
Implications for the Fed
Milan’s analysis indicates that interest rate cuts may be on the horizon. With tariffs having a minimal effect on prices, they seem more like a one-off price adjustment rather than an inflationary trend the Fed needs to control.
Milan cautions that “continuing to tighten policy unnecessarily due to imbalances and statistical measurement issues since 2022 could lead to job losses.”
