How Tariffs Can Lower Inflation Without Hurting the Economy

The recent research from the San Francisco Federal Reserve raises an interesting question: why do tariffs impact the economy in seemingly contradictory ways?

After analyzing 150 years of data, the researchers found that tariff increases often lead to lower inflation rates and higher unemployment rates. This challenges the common belief that tariffs boost employment while driving up inflation.

The authors suggest this might be because tariffs create a “demand and destruction” scenario: They deter investors, tighten financial conditions, and ultimately reduce overall demand. They highlight two potential factors contributing to this: increased uncertainty regarding economic policies and a decline in asset prices. Either way, it seems to lead to reduced investment and spending, resulting in fewer jobs and lower prices.

This explanation makes sense, but other interpretations might better align with the data from the San Francisco Fed, especially when considering the policy choices made during President Trump’s administration. For a long time, the U.S. economy—particularly in the trade sector—has struggled with a balance of low wages and low productivity. However, it’s important to note that this isn’t necessarily the only way to structure an economy, and definitely not the most effective.

The Route to a Low-Wage, Low-Productivity Economy

With minimal tariffs and open markets, domestic companies faced persistent pressure to lower prices. Foreign competitors set the bar, making it crucial for U.S. firms to cut costs. The simplest answer? Keep wages low, avoid investing in better infrastructure, and hire many low-skilled workers. This creates a low-wage equilibrium where wages stagnate, productivity doesn’t improve, and, while employment levels might look good, they often lack stability.

This reality essentially embodies what “competing with China” represents in policy discussions—importing a low-wage production model directly into our labor market.

Now, think about what imposing broad tariffs would do in this context.

Structural Changes for Enhanced American Productivity

When blanket tariffs are enacted, as opposed to targeted ones, three significant changes occur:

• First, foreign cost pressures diminish. Domestic firms no longer need to keep up with Chinese pricing to survive. The intense wage competition from abroad eases up.
• Second, workers gain bargaining power. Employers can’t easily threaten to outsource jobs. Moreover, raising tariffs sends a signal that the U.S. public is committed to supporting local production. This shift can improve leverage in wage negotiations, affecting tradable sectors and, eventually, even services.
• Lastly, cheap labor becomes more expensive relative to capital. As wage floors rise and the supply of low-skilled workers becomes limited, the model of simply hiring more becomes less viable. Instead, investing in machinery, reorganizing production, and training employees becomes a more appealing route.

Now, add in a broader policy framework: restrictions on low-skill immigration to limit wage-suppressing workers, efforts to lower spending and capital taxes, and pressure to reduce interest rates. This creates a clear direction: companies veer away from maintaining sweatshop conditions domestically and begin investing in capital to enhance productivity.

From this perspective, tariffs fundamentally shift production methods, not merely squeeze aggregate demand. Companies are often burdened with unproductive labor and minimal investment. The goal becomes fewer workers but more capital, leading to higher productivity and wages. This means that while some jobs at the lower end of the productivity scale might vanish, the remaining jobs would be more rewarding both in terms of fulfillment and pay. The overall output could improve too. However, boosting capital stock and optimizing processes may lead to fewer required workers.

This shift could create a rise in unemployment rate statistics, even as total production grows. Sure, some low-skill jobs might go away, and some individuals may struggle during this transition. Yet, this is likely just a temporary phase. As the economy evolves toward higher productivity levels, the investments in domestic manufacturing should eventually benefit the workforce, helping workers transition back into the fold.

Thus, the unemployment effects noted in the San Francisco Fed’s findings are, in fact, what one might expect: a structural migration away from unproductive roles rather than a collapse in overall demand.

Understanding Price Declines

Now comes the more complex part: tariffs and inflation. Many people argue that tariffs increase costs, which should also lead to rising prices. However, the San Francisco Fed’s historical analysis suggests the opposite has been observed. How can this be reconciled?

The key lies in the concept of unit labor cost—the cost of wages required to produce a single unit of output. This is a straightforward calculation: it’s the wage per worker divided by the productivity per worker.

Tariffs combined with Trump-era policies push both sides of this equation simultaneously. As tariffs boost workers’ bargaining power and tighten the labor market by reducing the influx of low-skilled immigration, wages can rise. Correspondingly, companies respond to these wage pressures and the availability of cheaper capital by investing in training, machinery, and better software, leading to increased productivity.

If productivity growth outpaces wage increases, unit labor costs can actually decline. Even if workers earn more per hour, producing each unit becomes less expensive.

In a competitive, or semi-competitive market, companies can’t sustain low unit prices indefinitely. These savings will likely translate into lower consumer prices or a softer pass-through of tariffs than traditional models might predict.

This may explain why the San Francisco Fed witnessed disinflation instead of inflation following tariff hikes. It didn’t merely suppress demand; it shifted the entire supply side from low productivity toward high productivity. Even with elevated wages, unit production costs remained low.

Two Narratives, One Dataset

This distinction is crucial because either analysis could fit the data from the San Francisco Fed. The same outcomes can be interpreted through two different frameworks.

In a demand and destruction narrative, tariffs create uncertainty, harming confidence and tightening credit. Households and businesses cut back on spending, leading to decreased demand, rising unemployment, and lower inflation.

Counterpoint, from the supply perspective, tariffs, immigration limits, capital tax reductions, and pressure on tax rates converge to make a low-wage, low-productivity approach unsustainable. As firms begin to invest and restructure, low-productivity jobs diminish while high-productivity roles grow. Yes, this transitional phase may temporarily spike unemployment, but the resulting supply side will yield higher real wages and reduced unit costs.

The pressing question is: which narrative corresponds more accurately to the actual policy mix? President Trump’s approach merges tariffs, immigration restrictions, capital incentives, and monetary support. Historical trends indicate that the nation has reduced unproductive jobs while enhancing real wages for those who remain employed.

In both scenarios, the supply-side story holds more weight.

This doesn’t imply that every conceivable tariff is justified, nor that we should impose tariffs on all goods without consideration. Given that inflation remains relatively high, perhaps it would be wise to consider slightly increased tariffs.

Essentially, the San Francisco Fed’s research shouldn’t solely be seen as proof that tariffs affect demand. Rather, it serves as evidence that combining tariffs with immigration, capital, and monetary policies can disrupt the low-wage equilibrium, steering the economy toward greater capital investment, augmented productivity, enhanced real wages, and lower price trajectories.