Incorporate the tariff impetus to inflation, on Wednesday and beyond

There are two reasons to expect the Summary of Economic Projections (SEP) released after Wednesday’s FOMC meeting to include an upward revision to the core PCE inflation forecast.  This applies especially to the year-end 2025 forecast, which is well inside the window at which the Fed might be expected to exert much influence over the inflation rate. *  

 

The first is just a base effect.  If core PCE inflation were to run at a sequential rate of 2 3/8% through the end of the year, as I assume, and if there were no revisions to the price data from now through year end, then the 4-quarter change of the Core PCE Price Index would end 2025 at just over 2.6%.  That would be 10 basis points above the last SEP projection, produced in December, of 2.5%.

 

Second, while we do not know what tariffs will be implemented and for how long, it seems reasonable to expect FOMC members to pencil in at least a noticeable inflation impetus from this source.  

 

I hasten to add what I take to be the most practically important knowable aspect of this story.  The reason that tariffs will not generate a sustained rise of inflation is largely that (real) aggregate demand growth will slow to prevent that outcome.  If the tariffs are paired with an income tax cut, then the Fed may have to deliver tighter financial conditions to secure the required growth slowdown. If tariffs are not paired with an income tax cut, which would be odd, then the economy would be more inclined to slow on its own.  But it is probably not an oversimplification to insist that higher tariffs = slower real growth for the next couple years.  

 

Returning to the specific point of this note, though, the odds would seem to favor the median inflation guess within the SEP incorporating at least some recognition of at least the first-round effects of some tariff increases. 

 

In this note, I quickly run through some of the arithmetic behind the points made above. I then conclude by speculating that it would be difficult for the Fed fully  to “look through” Trump going tariff heavy, if that risk were to be realized. What Trump will actually deliver here remains unknown, although the risk of aggressive tariffs has clearly risen over the past few weeks. 

A reasonable simulation if Trump were to go tariff heavy

Let’s start with the influence of the base effect, which is easiest to assess.  What I call the single best measure of inflation in the goods and services market suggests that the underlying inflation rate is currently stable at 2 ¼%. The 12-month change in the relevant index is closer to 2%, but its exclusion of non-market prices (to reduce noise) generates a hopefully stable downward bias of about 20 basis points.  Separately, the single best measure replaces the lagging government measures of average rents with my estimate of marginal rents, which I think is a real advantage. However, if we are trying to work up a mechanical estimate of the path of the Core PCE Price Index itself, then we need to add back the effect of average rents continuing to run ahead of marginal rents (even if by a narrowing spread) through the end of this year.  And that gets us to the 2 3/8% sequential rate in the Core PCE Price Index, which alone requires the Fed to revise up its year-end 2025 forecast by 10 bps. 

 

Within the FOMC, there will be some analysts favoring a more hawkish simulation than I have run here and some favoring a more dovish. But I think what I have set out here should be a roughly fair depiction of how the median guesser will see things. 

 

The bigger issue is the second one involving how to think about the tariffs. There are three big sources of uncertainty here:

• What tariffs will be implemented
• What the impact of those tariffs might be
•  How the Fed will reflect the two considerations above

Let’s focus here on the second item in the list on the grounds it might be the least subjective.  To be sure, there is plenty of uncertainty even here. In a note I sent out a couple weeks ago, I suggested that a recent research piece published to the FEDSNotes section of the Board’s website could be interpreted as implying as implying that Trump tariffing China imports at a rate of 20% and imports from Mexico, Canada and Europe at a rate of 20% might imply a 2 percentage point increment to the 4-quarter inflation rate lasting about a year, after which a slow fade would set in.  That interpretation is admittedly hawkish relative to other research I have seen on this issue. It incorporates both the tendency of domestic firms to raise their prices in response to higher prices on imported goods and (an offsetting) tendency for aggregate demand growth to slow in response to (any) tax increase.  It fits my main substantial point that higher tariffs necessarily mean slower aggregate demand growth, although we can argue about the path of financial conditions that will be required to deliver the slower growth. 

 

A more conservative (in the sense of avoiding overstatement) would be to follow the results of a recent Federal Reserve Bank of Boston research piece that looks only at the first round effects of tariff increases.  Boston conducts what is effectively an accounting exercise in which they look at (among other things) the import value added from individual countries and regions in core personal consumption expenditure.  This takes account of neither domestic suppliers responding to higher import prices (which would be additive) or the effects on aggregate demand growth (which would be tempering). Accordingly, the authors at Boston suggest the all-in or general equilibrium effects might be smaller than they model.  Ok, fair point. But it does not overturn what I take to the main point in this discussion, that higher tariffs imply (by requiring) slower aggregate demand growth.  And for the purposes of this current exercise the first-round impact effects may be what most interest us.

 

They estimate that applying an additional 10 percentage points to China imports and 25 percentage points to Mexico and Canada imports would raise the Price Index by 50 to 85 basis points.  Taking the midpoint of that range and then scaling up to include a 25 percent tariff against European imports gets me to a nice round percentage point.  If we were to assume that the median FOMC guesser were to assume half this program / effect, as well as the smaller base effect issue discussed above, then that would map to 3% Core PCE inflation in the SEP figure for the end of 2025, followed presumably by a very rapid fade.  But there is much uncertainty around the economics here, and then additional uncertainty around what program will be implemented and then how the Fed will assess all that. My best guess is that they go to 2.7% and that risks are slightly to the right.  They would be further to the right if the Fed did not have a tendency to lowball the effects of shocks in their initial speculations on them. 

 

Let me conclude here by moving beyond what the median guesser will write down on Wednesday and consider the larger question of the Fed “looking through” a presumably one-off effect of Trump possibly going tariff heavy.  To focus our minds a bit, let’s consider the chart above, which simulates how the 12-month rate of inflation, as implied by the single best measure, might behave in the event that Trump were to go tariff heavy along the lines I have described, and we were to get the first round impact that I infer from the Boston Fed study, against a baseline where underlying inflation is assumed flat at 2 ¼%. (This keeps it simple, by ignoring average rents.)  In setting out my simulation, I assume that the 1% impetus to the level of the Core PCE Price Index makes its way into the index within six months, but that assumption is not crucial to the main point made here. It has a minor effect on the peak inflation rate, which is offset by the speed of its retreat.

 

The main point to emphasize here is that the sum of underlying inflation and the tariff impetus accelerates quickly to well above 3%, assuming – as the simulation imposes – that the tariffs kick in immediately, i.e., in April.  Is this something that the Fed could look through?

 

In my view, the first part to getting the answer to that question right involves – as often – getting the question straight.  When doves, such as Governor Chris Waller, suggest that the Fed might be willing to “look through” this, there is an excellent chance that their looking relates to how they manage financial conditions. They will “look through” it by delivering the rates path expected and therefore, as a first approximation, unchanging financial conditions if (real) aggregate demand growth slows on its own. But, returning yet again to my main substantial point, this looking through is not at all at odds with the view that higher tariffs require slower aggregate demand growth.

 

Another aspect of getting the question right involves getting clear on the scale of what they are looking through. I think the Fed could look through, in the sense described above, an inflation impetus maybe 1/3 as large as that associated with tariff heavy, as modeled here.  If the blue line in the chart above is our future, and I concede it probably is not really, then the discussion of the Fed looking through will be moot. If the Fed does not raise the funds rate in that world, it is either because the stock market has gone down hard or the economy has really faltered in response to a confidence shock. 

 

And there is a final point that may be worth noting here, which does not involve just getting the question right.  In all these speculations, we are assuming that inflation expectations remain anchored and that one of the issues motivating the Fed is (merely) the fear that that might change. If measured inflation expectations were actually to begin dragging, then the outlook would darken further. For now, we assume that the Michigan Survey is not representative, in large part because the NY Fed measures of consumers remain stable and market-based measures of inflation expectations remain quite well behaved. But this will bear watching.  

 

* It is not that the Fed is unable to control inflation at a 9-month horizon. Rather, it is opposed to the dual mandate — and common sense, I guess — to try to do so.