Are tariffs inflationary?

Are tariffs inflationary?

Are tariffs inflationary? Any monetary economist would say “no” – at least not just tariffs by themselves. As the sainted Milton Friedman said “Inflation is always and everywhere a monetary phenomenon and is thus the responsibility of the central bank.” Although there are caveats to this, Friedman is fundamentally correct. This would mean that if Trump gets his way and the Fed lowers the Fed funds rate, the likely consequence will be more inflation. To explain this, let’s have a basic primer on how things should work. The Fed funds rate is the interest rate on overnight borrowings of banks’ excess reserves. To lower the rate the Fed increases the supply of excess reserves by purchasing securities from the banks. Given more excess reserves than they wish to hold, the banks then will seek to lend them out, creating more demand deposits and hence increasing the money supply. Whether the increased money supply increases inflation depends on how much slack there is in the economy. This means that in an economy with low unemployment the likelihood of the increase in money being inflationary is high. If the banks do not lend out the new excess reserves, they can still earn interest on the reserves paid to them by the Fed.

So the process by which the Fed funds rate is lowered by the Fed creates money. The empirical question what in this instance will be the impact on prices? The Fed seems to think that in today’s environment the impact will be inflationary. But it is not the tariffs themselves that are inflationary but the response by the Fed that causes the inflation. Let us suppose that most of the tariffs are passed on to consumers and that the Fed does not lower the Fed funds rate. The prices of imported consumer goods go up as well as the prices paid by businesses who use imported products as inputs in the production process. If there is no change in the money supply then there is no inflation even though the Consumer Price Index and the Producer Price Index will rise. How can that be? Well think of inflation as the air in a balloon. If no more air (money supply) is added to the balloon then it will be like squeezing on the balloon with some prices increasing and other prices decreasing but no inflation since inflation is defined as an increase in the general level of prices. Looking at the CPI and PPI will then be misleading. One would have to look at a more inclusive measure such as the GDP deflator to see the overall price effect.

The CPI measures a market basket of goods purchased by urban households. So that basket of goods could increase in price but if goods not included in the basket decreased in price the CPI would show inflation when in reality there would be no inflation. Again one would have to look to the broader measure, here being the GDP deflator that accounts for the prices of all goods and services.

At the Fed’s annual conference in Jackson Hole, Wyoming (which I used to be invited when I was an important person) Powell said “the effects of the tariffs on consumer prices are now clearly visible.” Powell then said that the “reasonable base case” is there would likely be a one-time step-up in the price level — though it’s important to note that “one-time” does not mean all at once and evolving tariff schedules could keep the adjustment alive for a while. In other words the Fed expects that the impact of the tariffs will raise prices and that the prices level will remain at the new higher level but there will not be “persistent” inflation. That means that absent an accommodating increase in the money supply, the higher price level stays on that plane and does not keep increasing year to year. Powell then said that the Fed “will not allow a one-time price increase in the price level to become an on-going inflation problem.” Translation: the Fed will not lower the Fed funds rate which would allow continued inflation.

But here’s the rub. The Fed’s mandate is a dual mandate. It is to provide price stability (no inflation) and promote maximum employment. This dual mandate is in conflict with each other and the Fed must weigh which is the more important. I may be in the minority (no pun intended) but I wish that the Fed would ditch the full employment part of the mandate and concentrate on inflation. Consequently in our current economic environment where there is considerable job loss which I attribute to the president’s policies, there is incredible pressure on the Fed to lower the Fed funds rather thereby increasing the money supply with the likely consequence of increased inflation. Mind you the common measures of inflation have been rising well past the Fed’s target of 2 percent already.

The irony is that many pundits credit the president’s election to the Biden inflation. The president’s insistence on lowering the Fed funds rate may in turn lead to a higher rate of inflation that otherwise would not exist. The empirical question is if that occurs with the president and his party pay a price at the polls at the midterm?