Under a stiff tariff, boosting the economy takes priority over inflation for a central bank

Economists generally anticipate that tariffs will lead to higher prices for consumers and businesses in the country that imposes them. This expectation has tended to suggest two broad policy alternatives for a central bank. Option 1: Tighten monetary policy (raise interest rates) to counteract or forestall inflationary pressure. Option 2: “Look through” the imposed tariff—hold to the prior course on the premise that the tariff is just a one-time increase in the price level.

A new Minneapolis Fed working paper supports a third response to tariffs: expansionary monetary policy (Working Paper 810, “The Optimal Monetary Policy Response to Tariffs,” by Minneapolis Fed Monetary Advisor Javier Bianchi and Louphou Coulibaly of the University of Wisconsin–Madison).

In the dynamic, open-economy model designed by Bianchi and Coulibaly, prices do rise substantially in the wake of a new tariff. However, a greater harm arises from the related distortions in consumption, production, and employment. They find that in response to a universal tariff imposed by its home country, a central bank should be willing to allow higher inflation—beyond the direct effect of tariffs on import prices—to counter the economic inefficiencies the tariff causes.

The economists reach this conclusion by recognizing an externality in the process. Their model highlights that under a tariff, the perceived private cost of imported goods is greater than the social cost. Revenues from the tariff are returned to households via the government. But consumers of the imported good don’t perceive this benefit when confronting higher prices, and they cut back too much on purchasing imports. “To counteract the substitution effect of tariffs and mitigate the contraction of imports,” the economists write, “the optimal monetary policy stimulates employment and aggregate income.”

Consumption of imports falls less than otherwise; the expansion further boosts purchases of domestic goods. In other words, to combat the recessionary forces sparked by the tariff, inflation is the side effect worth tolerating. This general finding persists across variations and extensions of the baseline model, each exploring an assumption that speaks to real-world economic conditions: Is the tariff permanent or temporary? Anticipated or a surprise? Are domestic firms perfectly competitive or enjoying some level of inefficient price markup at the outset?

One of these scenarios models a 10 percent tariff imposed on all consumption goods and intermediate inputs (for example, raw metals or automobile parts). The model finds the optimal monetary policy leads to higher inflation, employment, and output in the short run, supporting higher purchases of imports and domestic goods versus a look-through policy (see figure).

In this extension of the model, tariffs raise input prices and thus the marginal costs of domestic producers. The optimal policy remains one in which the central bank maximizes welfare by running the economy hotter than under a look-through policy that continued to target zero inflation for domestic goods.

Notably, while employment and GDP increase in the short run, they settle lower in the long run than they would have in the absence of tariffs, as the tariffs act as a long-run tax on labor.

Bianchi and Coulibaly take a moment to examine why a tariff looks different to a central bank than a terms-of-trade shock, in which import prices rise 10 percent for some non-tariff reason. The crucial difference is the capture and rebating of tariff revenues. In a terms-of-trade shock, the rise in import prices poses the same cost at the household level and the aggregate level—there is no inefficiency or misalignment between household choices and overall welfare. The optimal monetary policy response is, in this case, to look through the one-time shock.

The working paper also holds implications for the understanding of currency exchange rate responses under tariffs. Prior research has suggested that tariffs lead to increased demand for the domestic currency, and thus an appreciation of the exchange rate. Under the optimal, expansionary policy response to tariffs modeled by Bianchi and Coulibaly, however, the exchange rate depreciates as the central bank stimulates the economy and allows inflation to rise.

The economists acknowledge that they abstract from many complexities of today’s geopolitical and trade landscape, such as far-from-uniform tariff proposals and the prospect of escalating trade wars. Nonetheless, stylized models like theirs invite us to question assumptions and revisit our understanding of the mechanics of trade. “Tariffs are back as a policy tool,” they write. While price increases are one expected effect, their research finds other economic impacts could take priority for monetary policymakers.

Read the Minneapolis Fed working paper: “The Optimal Monetary Policy Response to Tariffs”