Inflation Resilience in a Tariff-Impacted Global Economy: The Role of Central Bank Credibility and Market Expectations

The global economy in 2025 is navigating a complex landscape shaped by escalating tariffs and the resulting inflationary pressures. As trade policies become increasingly protectionist, central banks face a dual challenge: mitigating the economic distortions caused by tariffs while maintaining credibility in their inflation-targeting mandates. This analysis explores how central bank credibility and market expectations are shaping inflation resilience in a tariff-impacted world, drawing on recent research and policy responses.

Tariffs as a Double-Edged Sword

Tariffs have emerged as a potent tool for reshaping trade flows, but their macroeconomic consequences are far from benign. By April 2025, the U.S. average effective tariff rate (AETR) had surged to 23%, up from 2.2% in 2024, driven by levies on imports from China, Canada, Mexico, and the EU Under a Stiff Tariff, Boosting the Economy Takes Priority Over Inflation for a Central Bank^[1]. These measures have directly inflated import prices, with the Harvard Business School Pricing Lab noting that tariffs have pushed import prices 5% higher and domestic prices above trend due to input cost pass-through The Impact of Tariffs on Inflation - Federal Reserve Bank of Boston^[4]. The Federal Reserve Bank of Boston estimates that a 60% tariff on Chinese goods alone could add 2.2 percentage points to core inflation How Should Central Banks Respond to US Tariffs? The RBA Provides Some Clues^[5].

However, tariffs also act as a "back-door tax" on labor, reducing global demand and suppressing economic growth Market Reactions to Tariff Announcements^[2]. This creates a paradox for central banks: while tariffs raise inflation, they simultaneously risk stoking unemployment and output contraction. A 2025 Minneapolis Fed working paper argues that under universal tariffs, central banks should adopt expansionary monetary policy to counteract these distortions, even if it means tolerating higher inflation Under a Stiff Tariff, Boosting the Economy Takes Priority Over Inflation for a Central Bank^[1]. This approach prioritizes short-term employment gains over strict inflation targeting, though it risks long-term economic inefficiencies as tariffs act as a persistent labor tax Under a Stiff Tariff, Boosting the Economy Takes Priority Over Inflation for a Central Bank^[1].

Central Bank Credibility: The Linchpin of Inflation Expectations

Central bank credibility has become a critical factor in anchoring inflation expectations amid tariff-driven volatility. When policymakers are perceived as committed to price stability, markets are more likely to trust that inflation will return to target, even in the face of supply-side shocks. However, the post-pandemic era has tested this credibility. The Federal Reserve's initial assertion that inflation was "transitory" in 2021 eroded trust, leading to a surge in inflation breakeven rates Inflation Expectations and the Credibility of Fed Policy^[3].

The divergence between short-term and long-term breakeven rates underscores this tension. As of 2025, the New York Fed's one-year-ahead inflation expectations have exceeded 2%, while the five-year breakeven rate remains closer to the 2% target Inflation Expectations and the Credibility of Fed Policy^[3]. This suggests that markets are pricing in near-term inflation persistence but retain confidence in central banks' long-term credibility. The European Central Bank (ECB) and Bank of Japan have similarly faced scrutiny, with the latter pausing its rate-hiking cycle due to uncertainty over U.S. tariffs' impact on export-driven economies The Impact of Tariffs on Inflation - Federal Reserve Bank of Boston^[4].

Navigating Uncertainty: Policy Responses and Communication Strategies

Central banks have adopted a "wait-and-see" approach to tariff-induced shocks, delaying rate cuts to assess their inflationary and growth impacts Market Reactions to Tariff Announcements^[2]. The Reserve Bank of Australia (RBA) exemplifies this strategy, outlining three global scenarios-trade war, trade peace, and baseline-to guide policy decisions How Should Central Banks Respond to US Tariffs? The RBA Provides Some Clues^[5]. In a trade war scenario, the RBA would prioritize growth by cutting rates despite inflationary pressures, while a return to trade peace might justify rate hikes to address inflation.

Communication has emerged as a vital tool in managing expectations. The ECB has refined its forward guidance to align with market-based indicators like inflation-linked swaps (ILS) and overnight indexed swaps (OIS) Central Bank Communication in a Polarised World^[6]. However, the complexity of central bank messaging can amplify market volatility, particularly in high-uncertainty environments. Studies show that ambiguous communication during tariff announcements-such as the April 2025 U.S. tariff shock-led to a 11% two-day drop in the S&P 500 and widened credit default swap (CDS) spreads for energy and consumer discretionary firms Market Reactions to Tariff Announcements^[2].

The Path Forward: Balancing Act for Inflation Resilience

For investors, the key takeaway is that inflation resilience in a tariff-impacted economy hinges on central bank credibility and the ability to manage expectations. While expansionary policies may provide short-term relief, they risk undermining long-term price stability. Conversely, overly aggressive tightening could exacerbate the recessionary effects of tariffs.

Central banks must strike a delicate balance: using targeted interventions to stabilize output while maintaining clear, transparent communication to anchor inflation expectations. The Minneapolis Fed's model suggests that a welfare-maximizing approach involves tolerating higher inflation temporarily to offset tariff-induced distortions Under a Stiff Tariff, Boosting the Economy Takes Priority Over Inflation for a Central Bank^[1]. However, this requires careful calibration to avoid eroding credibility, as seen in the Fed's post-2021 credibility crisis.

Conclusion

The interplay between tariffs, central bank credibility, and market expectations is reshaping global inflation dynamics. As trade policies continue to evolve, investors must monitor how central banks navigate this complex landscape. Those that maintain credibility through transparent communication and adaptive policy frameworks will likely foster greater inflation resilience, even in a protectionist world.