Fed does not consider tariffs to be inflationary
A question we often get asked is how the Federal Reserve is likely to react to President-elect Donald Trump's tariffs. Simply put, The Fed is likely to ignore them.
Critics of tariffs argue that:
There is no widely accepted economic model in which tariffs themselves are inflationary. Quite the opposite. Tariffs are taxes imposed on importers and reduce their income. All other things being equal, This is a deflationary impulse due to tariffs..
Additionally, customs duties may be imposed. boost the value of the dollar against foreign currencies. This would increase the purchasing power of the US dollar, which is also suffering from deflation. We saw exactly this dynamic when President Trump imposed tariffs on Chinese goods. There is a good argument that the depreciation of the Chinese currency was so strong that it partially undermined the effectiveness of the tariffs and allowed Chinese manufacturers to protect their market share despite the increased tariffs.
Of course, tariff critics argue that importers: Pass on the cost of tariffs It affects consumers and drives up the price of imported goods. However, a one-time price increase in response to tariffs is not sustainable inflation. Additionally, other prices are likely to be revised downward in response to consumers spending more on imported goods, with minimal impact on overall price levels.
The Fed expects any price increases to be temporary.
The Fed's response to rising prices due to tariffs will not be to raise interest rates. The Fed is not a machine that automatically responds to inputs such as rising prices. It is looking into the causes of price increases and trying to determine whether they are likely to continue and whether higher interest rates will effectively restore price stability. Remember when inflation started to pick up in the early days of the Biden administration? The Fed didn't respond. This is because they believed that inflation was temporary and assumed that significant inflation was caused by supply chain constraints.
In the case of tariffs, the Fed is likely to view the impact on prices as temporary. unlikely to be effectively offset by rate hikes. Ironically, some of the same people who argue that the Fed will raise rates in response to tariffs also believe that inflation is primarily the result of supply constraints, so the Fed will tighten too much in 2022 and 2023. claimed to be doing so. They correctly understood that the main impact of tariff increases would be on the demand side, meaning that they would not be very effective in controlling the “pass-through” price increases caused by tariffs.
surely, Fed staff models tariff impactthey found that increasing tariffs in response can reduce output and, in some cases, cause a recession. In other words, raising interest rates will have undesirable consequences. A better policy for the Fed would be to “see through” the price increases caused by tariffs. Inflation spikes briefly, but then falls quickly. As long as inflation expectations are fixed, there will be no long-term inflation problem that needs to be addressed through rate hikes.
What about growth? I also have the most pessimistic view on tariffs. US tariffs have not had a significant impact on growth. Rather, the impact will be due to the retaliation that many economists assume will follow a U.S. interest rate hike. But that's political science, not economics. Economists have no way of knowing how other countries' governments will react to tariffs. While some countries may temporarily retaliate by threatening tariffs, most quickly realized that access to the U.S. market was too important to risk escalating a trade war. We expect that you will notice.
To the extent that tariffs have a bigger impact on the economy than expected, This can be offset by tax reductions from customs revenue. and more accommodative monetary policy. After all, the Fed's job is to maintain price stability and maximum employment. If tariffs threaten jobs, the Fed will likely cut interest rates in response.
In other words, the idea that the Fed will tighten in response to tariffs is very wrong. The Fed's most likely response would be not to respond at all. Interest rate cuts are more likely than rate hikes.
