Tariff-Driven Inflation: Unraveling the Lagged Impact and the Fed's Dilemma

The U.S. economy is navigating a complex web of inflationary pressures, with tariffs emerging as a central, yet underappreciated, driver. While the Trump-era tariffs of 2018–2019 demonstrated a rapid pass-through to consumer prices—raising core goods inflation by 0.62 percentage points—the more recent 2025 tariffs have exhibited a muted but persistent effect. With a pass-through coefficient of 0.54, these newer levies have contributed 0.33 percentage points to core goods PCE inflation, translating to a 0.08-point drag on overall core PCE. This lagged impact, however, is far from benign. It underscores a broader reality: tariffs are not just a short-term shock but a structural inflationary force reshaping long-term expectations.

The Fed's Tightrope: Balancing Inflation and Employment

The Federal Reserve faces a precarious balancing act. In 2025, the Fed's dual mandate—price stability and maximum employment—is under strain. While headline inflation has stabilized at 2.7%, core CPI has surged to 3.1%, driven by sectors like apparel, motor vehicles, and medical care. These industries, heavily exposed to tariffs, have seen price surges outpacing the broader economy. For instance, infant and toddler apparel prices rose 3.3% in July 2025, while used vehicle prices climbed 0.5%, signaling the depletion of pre-tariff inventory.

The Fed's caution is warranted. Despite market expectations for a September rate cut—implied probability at 67%—Chair Jerome Powell has resisted, citing the risk of inflationary momentum. The challenge lies in distinguishing between transitory and persistent inflation. Tariff-driven price increases, unlike energy shocks, are embedded in supply chains and consumer behavior. As Goldman Sachs notes, tariff costs passed through to consumers could rise from 22% in June 2025 to 67% by October, amplifying inflationary pressures just as the Fed considers easing.

Challenging the Trump Narrative: Tariffs as Inflationary Catalysts

President Trump's assertion that tariffs have not caused inflation is increasingly at odds with empirical evidence. The Tax Foundation's modeling reveals that Trump-era tariffs have raised average effective tariff rates to 22.5%—the highest since 1909—and inflated consumer prices by 2.3% in the short term. Lower-income households, disproportionately reliant on imported goods, bear the brunt: the average household faces a $3,800 annual loss, with the second income decile paying 2.6 times more than the top decile.

Moreover, the delayed pass-through of tariffs is reshaping inflation expectations. Companies initially absorbed costs, but as inventories of pre-tariff goods are depleted, price hikes are accelerating. For example, apparel and footwear prices, which rose 1.4% in July 2025, are projected to climb 17% under full 2025 tariff scenarios. This dynamic suggests that inflationary pressures may persist well into 2026, complicating the Fed's ability to normalize rates.

Investment Implications: Hedging Against Stagflation

For investors, the implications are clear. The second half of 2025 demands a recalibration of portfolios to account for stagflationary risks. Here's how to position:

1. Inflation-Protected Assets: Treasury Inflation-Protected Securities (TIPS) and commodities like gold and copper are gaining traction. The TIPS yield spread over nominal Treasuries has widened to 1.2%, reflecting heightened inflation expectations.
2. Sector Rotation: Favor industries less exposed to tariffs, such as healthcare and technology, while avoiding manufacturing and retail. The S&P 500's energy and materials sectors have underperformed, down 8% year-to-date, while tech stocks remain resilient.
3. Currency Strategies: The U.S. dollar's strength is waning as investors bet on Fed easing. Emerging market currencies, particularly those of countries with trade surpluses (e.g., Brazil, India), offer attractive carry trades.

The Path Forward: Policy Uncertainty and Market Volatility

The Fed's next move will hinge on two critical factors: the pace of tariff pass-through and the durability of the labor market. With job growth slowing to 73,000 in July 2025 and layoffs surging to 750,000 in H1, the Fed may be forced to cut rates to avert a recession. However, premature easing risks entrenching inflation, particularly if the IEEPA tariffs are upheld in court. If these tariffs are permanently enjoined, the average effective tariff rate would drop to 4.1%, reducing inflationary pressures but also limiting the Fed's room to maneuver.

In this environment, investors must remain agile. The lagged impact of tariffs ensures that inflation expectations will remain unanchored, and the Fed's policy response will be reactive rather than proactive. For now, the playbook is clear: hedge against inflation, diversify across asset classes, and monitor the evolving tariff landscape. The second half of 2025 promises to be a test of both economic resilience and investment acumen.