The Mystery Deflation in the Fed’s Tariff Chart

Recently, we addressed how the New York Fed’s latest paper does not convincingly argue that tariffs have resulted in higher inflation.

The paper does enhance the previous analyses by the same group of economists by demonstrating that some of the tariff costs were indeed passed on to consumers. However, it fails to definitively link this to an overall increase in consumer goods prices—or even the complete range of consumer goods and services. It seems more accurate to say it has the potential to raise some prices while possibly lowering others.

What the Federal Reserve’s paper attempts to do is quantify how much faster prices increased for goods that were more subject to tariffs, either directly or via their inputs. The methodology assumes that goods not impacted by tariffs remained unaffected—at least those the economists believe had no exposure—and treats the changes in these goods as if they would have happened regardless. This scenario is dubbed the “counterfactual” non-tariff situation, used to gauge the impact of tariffs on pricing.

This means they haven’t proven that prices of tariffed goods would have behaved like those of non-tariffed goods actually did. They also haven’t shown that the prices of non-tariffed goods would have acted like they did if tariffs hadn’t existed. They simply operate under that assumption.

Now, to be fair to the Fed economists, they do clarify this in their paper. But, honestly, it’s presented in a way that’s probably confusing for anyone not deeply versed in economics. You have to look pretty far into the paper—like, all the way to page 20—to find wording that states:

“This counterfactual should be read with care. Like any regression with time fixed effects, our specifications identify the effect of tariffs on a good’s price relative to less-exposed goods; the common, economy-wide component is absorbed by the date fixed effects and is not separately identified: the familiar missing-intercept problem. The counterfactual therefore treats these relative price effects as absolute ones, and should be read as illustrative of the magnitude of the tariff-induced price increases for the goods in our sample.”

Did you catch that? “The familiar missing-intercept problem.” It’s a term that can make even those who are somewhat accustomed to economic literature glaze over. The counterfactual is presented as a key finding—that prices would have dropped one percent without tariffs—rather than, you know, something to approach with caution.

But the Fed’s interpretation of the data warrants more than just careful reading; it really calls for skepticism—almost scorn—because the most plausible outcome might be that while the prices of goods impacted by tariffs increased, the prices of goods not impacted decreased.

The NY Fed’s Chart Demonstrates Their Error

Interestingly, the best support for this hypothesis surfaces in a chart featured in the Fed paper and discussed in the New York Fed blog, Liberty Street Economics.

The red line reflects the actual price growth across the 67 categories of goods studied. The dashed blue line represents what the Fed terms the “counterfactual without tariffs.” The space between these lines accounts for the 2.9 percentage points that have been widely discussed.

Now, think about what that dashed line is suggesting. It shows that through 2024, prices for these goods were barely decreasing—hovering around a half percent—and were edging back to zero as 2025 rolled in. Then, according to the Fed’s counterfactual, goods deflation suddenly surged, reaching about minus 1.5 percent late last year.

Why would that occur? If you follow the pre-tariff price trajectory, it actually indicates inflation would be increasing, not a sudden dive into deflation. The chart implies there would have been an abrupt and dramatic shift in prices.

The reality is that the dashed line is not an independent projection. It’s the result when you deduct the Fed’s tariff estimation from real inflation. The methodology operates under the assumption that what remains would have occurred in isolation from tariffs. Yet, that residual trend plunges right as tariffs kick in.

The Fed’s chart only goes through February 2026. Brian LeBlanc, chief economist at PNC, extended this analysis, providing insight into what follows their cutoff.

LeBlanc incorporated the estimates from the Fed paper and reconstructed tariff exposures based on publicly available data. Frustratingly, the New York Fed didn’t share the particulars of the categories they categorized as tariff-impacted, so many have had to recreate their dataset. His extension focuses on core goods inflation, making it a reconstruction rather than a direct continuation of the chosen basket from the Fed.

This added perspective highlights the flaws in the Fed’s assumptions even further. The scenario without tariffs shows a striking deflationary trend coinciding with the arrival of tariffs, along with a sharp recovery when the estimated inflation contribution diminishes.

It’s quite telling that the Fed’s hypothetical world necessitates two unexplained shifts: a dramatic decline that aligns precisely with the introduction of tariffs, followed by a rebound that matches their reduction.

Tariffs Impact Some Prices Upward, Others Downward

The simplest explanation for the observed phenomenon is the one we touched on earlier. The higher prices resulting from tariffs likely strained spending on other items, leading to downward pressure on alternative prices. Tariffs did not increase households’ additional spending power. So, families cut back on purchases of some goods to accommodate the rising costs of others. Spending more on a washing machine meant they had less available for things like furniture, clothing, or dining out. After tariffs were fully integrated into pricing, the financial squeeze lessened, allowing other prices to recover.

The charts reveal that prices considered unaffected by tariffs actually mirrored the tariffed ones. These prices declined with the advent of tariffs and rose when the one-time price impacts faded. Prices responsive to tariffs are not truly independent; they reflect a more complex narrative.

In more technical terms, the New York Fed’s paper wrongly assumes that non-tariff prices operate independently when they are, in fact, affected together in opposite directions.

The Fed’s assertions hold some validity when they indicate that prices of goods affected by tariffs increased at a faster rate than those that weren’t. However, the misstep occurs when they leap to the conclusion that “tariffs raised inflation.” This conclusion hinges on the presumption that prices of non-tariffed goods could exist independent of tariffs—a notion the Fed’s own chart implies is inaccurate.

The dotted blue line from the Fed’s chart does not illustrate a reality without tariffs. Instead, it indicates that the influence of tariffs on goods inflation is minimal; in effect, tariffs raised some prices while simultaneously lowering others.