We are no longer in liquidity trap. So, things may work differently from what folks’ muscle memory suggests.
Bloomberg is reporting that Trump allies are urging income tax cuts to compensate for the damage to the economy that the tariffs will do. But the odds of that working are very low, because the issue here is inflation and the Fed imposing a speed limit to contain it, not a deficiency of aggregate demand. If aggregate demand deficiency were the issue, then the Fed would just cut rates. Recall that they now have plenty of room to do that. No, the issue is the speed limit on the demand growth. And the higher the tariff, the greater the inflation pressure, and the lower the speed limit.
I always find it fun to identify ironies. When the US economy was stuck in liquidity trap, many people for a long time failed to internalize important practical implications of that. One such was that fiscal expansion was an extremely good idea and that worries about fiscal sustainability were largely beside the point. Another was that the size of the monetary base was neither here nor there for anything. Now, we are away from liquidity trap, and the Fed has fully retrieved its traditional last mover advantage in determining aggregate demand growth – or the mean of the probability distribution describing its future path. And yet people are speaking as though an issue with the tariffs is that they hit aggregate demand. Sure they do. But they must, because that is how we contain the inflation impact to bad, rather than horrible.
Another irony here relates to Treasury Secretary Scott Bessent’s somewhat hilarious claim that tariffs do not cause inflation because the more money we spend on the tariffed good, the less money we have to spend on the non-tariffed good, whose price then falls. As I pointed out the first time I heard that, it is possible that some theoretical models could generate that result. To be honest, the validity of such models is beyond my pay grade. But if the fiscal policy is to replace income tax revenue with tariff revenue, then the income tax cuts provide the extra money so that there is just the same amount of money to spend on the non-tariffed good, so its price does not fall. That part is remedial arithmetic.
A tariff imposed in isolation will force the Fed to impose a lower speed limit on aggregate demand growth in order to prevent an acceleration of inflation. It is possible that such a lower speed limit can be imposed without the Fed having to tighten policy much, for the reason that Bessent was trying to allude to while flailing so badly. That is, the economy might weaken on its own. A revenue-neutral tariff paired to an income tax cut, just raises the path of the funds rate – or the tightness of financial conditions – to get the same growth result, at least as the central cast. (The Fed can make mistakes. It is just that the direction of those mistakes is idiosyncratic.) Remember, we are no longer in liquidity trap. Joe Biden saw to that, for good or ill. I would say there was some good and some bad. But the practical point is that we are no longer in liquidity trap and must accommodate our thinking to that fact.
