Potential Implications of Announced Tariffs for Monetary Policy

In this essay I will briefly discuss potential implications of the recent tariff announcements for the path of monetary policy.¹ Trade policy is not the purview of the Federal Reserve; it is the domain of Congress and the executive branch. However, trade is an important factor monetary policymakers must consider when analyzing and forecasting the path of the U.S. economy in order to determine how best to achieve the dual mandate goals of stable prices and maximum employment that Congress has assigned us.

At a public town hall in Detroit Lakes, Minnesota, on March 26, I commented that concerns about tariffs and a potential trade war had led to the biggest sudden drop in confidence in the past decade except for when COVID-19 hit the U.S. in March 2020. I noted that the shock to confidence could potentially have an even larger effect on the economy than the tariffs themselves. When people and businesses lose confidence, they pull back from spending and investing, potentially leading to a meaningful slowdown in economic activity, perhaps even to a recession.

While there remains enormous uncertainty today (Figure 1)—for example, the final size of tariffs, their duration, and other countries’ ultimate responses are still unknown—we now know the size and scope of the initial package of tariffs that were announced on April 2 (Figure 2). The announced tariffs turned out to be much higher and broader than expected, resulting in a corresponding larger direct economic effect and larger shock to confidence.

Implications of the Tariff Announcement for the Near-Term Economic Outlook

Analytically, in the short run, tariffs act like a consumption tax on American consumers and firms in the following ways:

• The federal government collects revenue from a tax on purchases of imported goods (Figure 3).
• The prices consumers and firms pay will go up; hence, inflation will climb, at least in the near term.
• Real purchasing power for consumers and firms will go down.
• Investment will likely be lower because the prices paid for imported capital goods will be higher.
• GDP growth will be smaller.
• Unemployment could be higher.

There is a case to be made that monetary policymakers should look through the inflation effects of a large consumption tax increase—since it could represent a one-time shift in the price level—and instead focus on any employment reduction. That would imply a somewhat lower path for monetary policy, all else equal. But context matters. Given the high inflation we’ve experienced in recent years and the risk of unanchoring long-run inflation expectations, I believe our first priority must be keeping long-run inflation expectations anchored. Anchored long-run inflation expectations have been foundational to the economic growth and competitiveness the U.S. has enjoyed in recent decades.

Hence, adopting a simple look-through policy could be too risky for the economy. While market data for long-run inflation expectations have not moved much in recent weeks, there has been a sharp move upward in measures of near-term inflation expectations that is important to watch (Figure 4). Once we are confident that inflation expectations are well anchored, we could then focus primarily on the traditional trade-offs between our dual mandate goals.

Implications of the Tariff Announcement on the Neutral Interest Rate

The neutral real interest rate, what we call r*, is the real interest rate that balances savings and investment in the economy. We believe the neutral rate in the long run is slow moving and is set by broader macroeconomic factors, such as productivity growth and demographics. The effects of the tariffs on r* in the long run are unclear. The outcome will depend on many factors, including what the government chooses to spend the increased tax revenues on, such as deficit reduction, cutting other taxes or funding new investments.

However, in the near term, r* will likely decline. The large increase in tariffs raises the prices firms will pay for capital goods sourced from abroad, and the significant increase in economic uncertainty will likely reduce firms’ desire to invest. Both factors push down r*. If the policy rate remains unchanged, a decline in the neutral rate in the near term would represent a net tightening of policy in response to the tariffs.

Overall Implications for Policy

In my view, the hurdle to change the federal funds rate one way or the other has increased due to the tariffs. Given the paramount importance of keeping long-run inflation expectations anchored and the likely boost to near-term inflation from tariffs, the bar for cutting rates even in the face of a weakening economy and potentially increased unemployment is higher. Given that we don’t yet know how many countries will respond to the tariffs and whether we are beginning a trade war with tit-for-tat tariff increases, the risk of unanchoring inflation expectations seems to have increased notably.

On the other hand, given that the demand for investment capital will likely be lower and push short-run r* down, policy is getting somewhat tighter on its own, reducing the immediate need to raise the federal funds rate to keep long-run inflation expectations anchored.

As recent weeks have reminded us, nothing is certain and no monetary policy response, up or down, should be completely off the table. Going forward, I will be paying close attention to further trade policy announcements from U.S. authorities and our major trading partners, to indications of expected inflation, and to the traditional measures of economic activity, actual inflation and employment. Either a rapid resolution of trade policy uncertainty or a sharper than expected downturn could lead me to revise my outlook for appropriate monetary policy.

Endnote

1 These comments are my own and do not necessarily represent the views of others on the Federal Open Market Committee or of the Federal Reserve System.