New Paper Challenges Fed’s Assumption on Tariffs
The Federal Reserve is facing a theoretical challenge rather than a policy one regarding tariffs. Traditionally, economists have seen tariffs as automatic inflation triggers—implementing duties on foreign goods simply results in rising prices, with no room for nuance or negotiation.
However, a recent academic paper by three trade economists utilizing Chinese microdata suggests that this view is flawed. Their findings indicate that customs duties aren’t just passed on; they are absorbed by exporters. This means that when absorption occurs at the exporters’ end, U.S. prices don’t rise as expected; in some instances, they even decrease.
The paper, “Revisiting the Passthrough of US Trade Policy: Evidence from Enterprise-Level Data,” authored by Chong Xiang (Purdue), Wei Xiong (Princeton), and Yifan Zhang (China University, Hong Kong), draws on Chinese customs records from the 2018-2019 trade war. Their analysis reveals that Chinese companies tend to reduce prices in response to U.S. tariffs. The notion of “full pass-through” at the product level can be misleading, masking the exit of low-cost firms from the U.S. market. A closer look shows that surviving exporters offer discounts to remain competitive.
Price Adjustments in Focus
Some key findings are noteworthy: the resilience of firm-level prices to tariffs stands at –0.063. Essentially, a 10-point rise in tariffs corresponds to a 0.63-point pricing drop on average. Interestingly, those companies that are more media-savvy cut prices even deeper—by 1.7 points for every 10-point tariff hike. These are the more robust exporters, often the premium brands, rather than lesser-known competitors.
On the other hand, low-margin companies that can’t lower prices fully face the brunt of the U.S. market. This creates a misleading average price that doesn’t reveal the concessions by businesses willing to stay in the game. One might glance at average prices and assume stability, but digging deeper unveils a different narrative. Foreign firms yielded under pressure; in many ways, Trump’s tariffs proved effective.
Reassessing Tariff Impacts
This analysis isn’t just an exercise in theory—it represents a crucial lens through which to view Trump’s tariff landscape. Federal Reserve Chair Jerome Powell has often stated that the consensus among his discussions is that tariffs lead to inflation.
Nonetheless, as the patterns from Xiang, Xiong, and Zhang recur, numerous foreign exporters seem willing to absorb costs. It’s not merely obligation; it’s a strategic choice to maintain market share in the U.S. Whether you’re a German car maker or a Korean chip manufacturer, giving up sales over minor tariffs isn’t an option. They lower prices, streamline operations, and hope for political shifts.
That’s precisely what Chinese exporters accomplished last time around, and it seems the Fed hasn’t fully grasped this dynamic yet.
Understanding Inflation Models Better
The Fed’s prevailing model views tariffs as direct taxes on American consumers. However, reality is considerably more layered. Tariffs can not only act as price pressure but also serve as negotiation tactics. They compel foreign suppliers to make a choice: maintain prices and lose customers, or trim margins and stay afloat. Many opted for the latter during 2018 and 2019.
This is significant. If central bankers remain fixated on tariff-induced inflation increases, they risk over-tightening an already softening economy. They may be chasing shadows. A more prudent strategy would involve closely observing import prices, assessing unit values, and paying attention to the bottom line for foreign companies selling in the U.S. If overseas margins are shrinking, tariffs are fulfilling their role, without triggering inflation here.
Ultimately, Trump’s initial tariffs revealed a critical lesson that the Fed seems to overlook: foreign exporters possess pricing power, and under duress, they deploy it. The research by Xiang, Xiong, and Zhang puts concrete evidence on the table—it’s possible to avoid increasing prices due to customs duties, and in some cases, they can actually reduce them.
