Tariffs and Inflation: The Fed's Near-Term Concerns

The Federal Reserve's recent decision to hold interest rates steady at 4.25% to 4.50% has sparked a lot of discussion, especially in light of President Donald Trump's aggressive economic agenda. The Fed's stance is clear: tariffs will drive inflation up in the near term, and the central bank is preparing for the potential fallout.



Fed Chair Jerome Powell acknowledged the high level of uncertainty among American consumers and businesses, much of it stemming from the Trump administration’s “turmoil.” Powell said that “it remains to be seen how these developments affect future spending and investment.” The Fed’s key borrowing rate remains in the 4.25% to 4.5% range, allowing Fed policymakers to see how the Trump administration’s flurry of policy changes ultimately affects the US economy.

The Fed’s latest pause marks the second time in a row that the central bank held borrowing costs steady. Fed policymakers also expect the economy to be weaker this year than previously thought, according to the projections. They also forecast inflation to be higher this year. To put it simply, as the Trump administration sets out to enact structural changes, Fed officials see the US economy trending toward “stagflation,” a troubling combination of sluggish or negative growth and accelerating inflation.

The Fed’s projections for 2025 GDP growth have been lowered to 1.7%, down from the previous 2.1% estimate. This reduction in growth expectations can be partly attributed to the uncertainty and higher costs associated with tariffs. The Fed has also raised its inflation expectations, projecting 2.8% core PCE inflation compared to its previous 2.5% projection. Powell noted that Trump administration policies on trade, immigration, fiscal policy, and deregulation “will matter for the economy and the path of monetary policy.”

The impact of tariffs on inflation is not just a near-term concern. The methodology developed by the Federal Reserve Bank of Boston quantifies how price increases at the border transmit to US consumers. It estimates that an additional 25 percent tariff on goods from Canada and Mexico combined with an additional 10 percent tariff on goods from China could add as much as 0.8 percentage point to core (excluding food and energy) inflation. This is because most producers and retailers charge a large markup on top of costs, and these markups respond to cost changes of imported components.

For example, in the light trucks category, which includes vans, pickups, and SUVs, spending on new light trucks accounts for about 1.6 percent of American households’ total consumption. Of the $136 billion from US households that went to producers, about 60 percent (or $80 billion) was spent on domestically built trucks and about 40 percent (or $56 billion) on foreign-built (imported) trucks. Therefore, US households spent $56 billion on direct imports of new light trucks. However, households that buy American-made trucks are not immune from fluctuations in import prices. This becomes apparent when we further break down domestic light truck expenditure into gross operating surplus, compensation of employees, and cost of intermediate goods. For example, engines constitute $6 billion of US light truck producers’ cost of materials, and 40 percent of these engines are imported. In turn, domestically produced engines contain imported parts. Our methodology enables us to compute that overall, $20 billion from US households is spent on indirect imports within the light truck category, over and above the $56 billion spent directly on imported light trucks.

The methodology generalizes the logic of the light truck example to capture the entire imported content of US consumption. It uses input-output tables and PCE bridge tables from the US Bureau of Economic Analysis (BEA) that detail the supply-chain relationship between 402 commodity-by-industry categories in the United States as well as each industry's gross operating profits and compensation of employees. The Appendix provides a detailed description of our methodology, which borrows from Baqaee and Rubbo (2023) and Silva (2024). To the best of our knowledge, our approach is first to account for the magnitude of retail markups in its calculations and to consider a plausible range of assumptions about how markups will respond to import price changes.

Overall, we estimate that 6 percent of core PCE is directly imported, and 4 percent is indirectly imported; that is, spending on direct and indirect imports accounts for 10 percent of core PCE. This means that tariffs can have a significant impact on inflation, as they increase the cost of imported goods, which in turn increases the cost of domestically produced goods that contain imported components. This can lead to higher production costs and ultimately higher prices for consumers, contributing to inflation in the near term.

The potential long-term effects of tariffs on the U.S. economy can be significant and multifaceted, differing from the near-term impacts in several ways. Near-term impacts often include immediate price increases and supply chain disruptions, while long-term effects can encompass broader economic shifts and structural changes.

Near-Term Impacts:
1. Immediate Price Increases: Tariffs can lead to immediate price increases for goods that are subject to higher import taxes. For example, an additional 25% tariff on goods from Canada and Mexico combined with a 10% tariff on goods from China could add as much as 0.8 percentage point to core inflation. This is a direct result of the increased cost of imported goods, which can be passed on to consumers.
2. Supply Chain Disruptions: Tariffs can disrupt supply chains, leading to shortages and delays in the production of goods that rely on imported components. For instance, the light truck industry, which includes vans, pickups, and SUVs, spends a significant portion of its costs on imported components. An increase in import prices can lead to higher costs for domestic producers, affecting the final consumer prices.

Long-Term Effects:
1. Inflationary Pressures: The long-term effects of tariffs on inflation can be more persistent. For example, a shift in trade costs somewhat more severe than the one observed during tariff hikes in the late 2010s leads to persistently higher inflation. This is because disruptions affecting intermediate inputs reduce firms' production efficiency, leading to higher production costs and, consequently, higher prices for consumers.
2. Economic Growth: Tariffs can have a long-term impact on economic growth by reducing overall productivity and efficiency. For instance, the Fed's projections for 2025 GDP growth have been lowered to 1.7%, down from the previous 2.1% estimate. This reduction in growth expectations can be partly attributed to the uncertainty and higher costs associated with tariffs.
3. Labor Market: Tariffs can also affect the labor market in the long term. For example, President Trump's aggressive crackdown on immigration can cause labor shortages in certain industries, while his mass layoffs of federal workers could send some local economies into a recession. These changes can lead to structural shifts in the labor market, affecting employment rates and wage growth.
4. Trade Relations: The long-term effects of tariffs on trade relations can be significant. For instance, the implementation of sustained taxes on exports similar to those proposed could cut S&P 500 Index earnings per share by 2-3%. This is because tariffs can lead to retaliatory measures from other countries, affecting the overall trade environment and the profitability of U.S. companies.
5. Currency Value: Tariffs can also potentially drive up the value of the dollar, according to goldman sachs Research foreign exchange analysts. A stronger dollar could further weigh on the earnings of S&P 500 companies, which derive 28% of revenues outside the U.S. This can have long-term implications for the competitiveness of U.S. companies in the global market.

In summary, while the near-term impacts of tariffs are often immediate and visible, such as price increases and supply chain disruptions, the long-term effects can be more profound and far-reaching, affecting inflation, economic growth, the labor market, trade relations, and currency value. The Fed is clearly concerned about the near-term impact of tariffs on inflation, and investors should be prepared for potential volatility in the months ahead.