U.S. Federal Reserve officials remain uncertain about the impact tariffs might have on inflation, but have begun outlining more serious risks to supply chains, public expectations and ultimately prices as the scope of the Trump administration's plans for import taxes has become clearer.
The trade war touched off during President Donald Trump's first term eventually prompted the Fed to lower interest rates because, rather than feeding inflation, the global and U.S. growth outlook began to dim.
But with a high inflation episode still top of mind, consumers still spending, and higher sensitivity at the Fed to how supply disruptions can create persistent inflation, the sweep and extent of Trump's plans are causing concern.
The administration's piecemeal approach may in particular be damaging, Fed officials say, as businesses and consumers adjust to an outlook that seems both unpredictable and primed for higher prices.
“Most tariffs lead to a one-time shock and then the world moves on," Atlanta Fed President Raphael Bostic said earlier this month. But if debate, implementation and retaliation spool out over time and start to affect inflation expectations, "it would be appropriate to respond" through monetary policy.
Not all Fed officials are as concerned.
Fed Governor Christopher Waller said on Monday he does not expect tariffs to trigger persistent inflation and believes central bankers should respond to the data in front of them. Waiting for perfect certainty even in volatile times "is a recipe for policy paralysis," Waller said.
Minutes of the Fed's January meeting due on Wednesday may provide more detail about officials' debates about Trump's promised agenda. The meeting occurred just a week after Trump's inauguration, but uncertainty was already rising and added to policymakers' reluctance to cut interest rates further until they had more information on how Trump's policies would affect the economy.
'SUPPRESSIVE EFFECT'
Administration officials argue their plans, which also include tax cuts, deregulation and crackdowns on immigration, will ultimately lower inflation, a view not widely shared by economists.
A recent paper by Boston Fed researchers concluded that tariffs of 25% on Mexico and Canada and 10% on China would add 0.8 percentage point to inflation, a blow to the Fed's outlook.
But that estimate, the paper noted, did not include the myriad adjustments that tariffs would trigger: Consumers may substitute goods or cut demand; businesses may eat the cost or pass it on; other countries may retaliate; and global exchange and interest rates will adjust. "We would expect (such dynamics) to dampen our inflation estimates due to their suppressive effect on economic growth," the authors noted.
That "suppressive effect" dominated in Trump's first term. The price impact was muted, one study found, because retailers absorbed much of the cost through lower profit margins.
This time, Fed officials say business contacts are blunt about plans to pass tariff costs to consumers, emboldened by pandemic-era inflation to test their pricing power.
"I do believe that businesses are more likely to pass cost pressures on than they were five years ago," Richmond Fed President Thomas Barkin said in January. Once that process is started "you'd have to worry about expectations" given inflation memories remain fresh among consumers.
"In the aggregate, you're...going to see higher prices and lower activity,” said Minneapolis Fed research director Andrea Raffo. “How big these forces are depends on...which goods are taxed, and if it is easy to substitute away or not." Uncertainty will cause a further drag.
SUPPLY MATTERS
A survey done after Trump's election by economists Olivier Coibion, Yuriy Gorodnichenko, and Michael Weber found about a third of firms were prepared to raise prices, while about half of all respondents expected prices to rise. About 28% accepted Trump's arguments that foreign companies will pay for tariffs.
So far, Fed officials say they don't see consumers or markets losing confidence in the central bank's ability and willingness to return inflation to 2%. With the policy rate at what they still consider a "restrictive" level, they see the stage set for price pressures to ease.
Moreover, the confluence of conditions - low unemployment, above-trend economic growth, consumers still eager to spend, and businesses newly conditioned to raise prices - could produce different outcomes than in Trump's first term. Then, output was below the economy's estimated capacity, and inflation largely remained below 2%.
Chicago Fed President Austan Goolsbee argues recent experience should keep policymakers cautious about how easily the economy will adjust to any tariff shock.
"If in 2018 companies shifted all the easiest things out of China, then what’s left might be the least substitutable goods. In that case, the impact on inflation might be much larger this time," Goolsbee said. Neither should the impact on complex and integrated supply chains be downplayed.
While Trump aims to bring those supply chains onto American shores, the pandemic showed how disruptions and lengthy adjustments can produce more persistent inflation pressure.
"The supply side of the economy cannot be an afterthought," Goolsbee said.
