Tariffs and Inflation: Uncertain Future Ahead

Mixed Signals on Tariff Impacts

Recent economic data continue to present a complex picture of how tariffs are influencing prices in the United States. This has led to uncertainty among financial markets about who is ultimately bearing the costs. While businesses have been absorbing much of the tariff burden, it remains unclear how long they can sustain this or how much pressure consumers will face in the future.

Months after President Donald Trump initiated his trade war, the impact of tariffs on U.S. prices remains inconsistent. The consumer price index has risen slightly but has consistently fallen short of expectations. However, the latest producer price data surprised analysts by showing higher-than-expected increases.

Some sectors that are heavily affected by tariffs have experienced price hikes, but recent July data indicated less upward pressure on goods prices and more on services. Despite these fluctuations, JPMorgan economists, led by Michael Feroli, noted that the effect of tariffs on consumer prices has been less severe than anticipated.

One possible reason for the lower inflation numbers is that companies are absorbing the tariff costs, which has allowed them to maintain profit margins. These margins are currently wider than historical averages, giving firms some room to handle additional expenses without affecting their budgets.

Other factors contributing to the muted inflation include the delayed impact of tariffs as companies use up pre-tariff inventory, seasonal variations in pricing, and the fact that some tariff costs are being passed through via services rather than goods. A recent Barclays report also highlighted that the actual tariff rates paid by importers are often lower than the headline figures. For example, in May, the weighted-average levy was 9%, compared to an estimated 12%.

This discrepancy occurs because demand has shifted away from countries with higher tariffs, and more than half of U.S. imports during that period were duty-free. Even though Canada faces higher tariffs, many goods are exempt under the U.S.-Mexico-Canada trade agreement.

Barclays noted that the effective tariff rate has increased slightly to 10% and expects it to rise to around 15% as more products face levies and existing loopholes close.

Business vs. Consumer Burden

Citi Research does not see significant evidence of broad price pressures from tariffs. They attribute recent service price increases to one-time events, such as a 5.8% rise in portfolio management fees due to asset price gains. Citi also believes that consumers are unlikely to face major price hikes, even as more tariffs are implemented.

According to Andrew Hollenhorst, chief U.S. economist at Citi, softer demand makes it difficult for companies to pass on tariff costs to consumers. While some firms might gradually increase prices, these increases are expected to be modest, reducing concerns about inflation and increasing worries about potential hiring cuts due to shrinking profit margins.

In contrast, Goldman Sachs predicts that consumers will bear the majority of the tariff costs. As of June, consumers had absorbed 22% of the costs, but this is expected to rise to 67% by October if current trends continue. Meanwhile, the burden on businesses would decrease from 64% to 8%, while foreign suppliers would see an increase from 14% to 25%.

Implications for the Federal Reserve

Understanding the effects of tariffs on inflation is crucial for the Federal Reserve, which must balance its dual mandate of price stability and maximum employment. Tariffs have kept inflation above the Fed’s 2% target, leading to delays in rate cuts. However, weak job market data have raised concerns about employment, prompting calls for monetary easing.

Citi's Hollenhorst stated that so far, most of the tariff costs have been borne by domestic firms. The lack of cost pass-through should ease inflation concerns, potentially allowing for rate cuts starting in September. Markets may be underestimating the possibility of faster or deeper rate reductions.