A groundbreaking new economic study from a regional Federal Reserve Bank may upend economic thought on the impacts of tariffs.
Researchers examined 150 years of tariff policy in the U.S. and several other countries, concluding that tariffs lower inflation but raise unemployment. This contradicts economic thought that tariffs are an effective “tax” on consumers or raise prices for consumers.
This research comes at a pivotal moment. President Donald Trump has sought to rebalance trade by renegotiating tariffs with virtually every nation, including our largest trading partners to the north and south. The U.S. Supreme Court is also considering the constitutionality of these tariffs. Economists expected the U.S. economy would falter into recession this year because of tariffs, but many have changed their positions. If tariffs are not inflationary, it may be time to rewrite the economics books.
Findings
A new working paper by researchers at the San Francisco Federal Reserve Bank adds tremendous value to the national policy about tariffs. Previous research has only examined tariff impacts on specific sectors and provided insight into how much of a price increase from tariffs gets passed through to consumers. By themselves, these studies have some value, but are far less insightful than examining the total macroeconomic effects of tariff changes. This new study provides economy-wide data on the pros and cons of tariffs.
What they found was compelling:
Regardless of our identification approach, we obtain the same result: a tariff hike lowers CPI inflation and raises unemployment. Interestingly, our results also hold for the modern post World War II sample period. While the results are more uncertain (which is expected given the much smaller variance of tariff changes since 1945), the point estimates remain statistically significant and continue to point in the same direction: higher tariffs lead to lower economic activity and lower inflation in the short-run.
Diving into why this is happening, researchers provide two explanations from historical experiences:
Tariff shocks appear to act as aggregate demand shocks—moving inflation and unemployment in the same directions. A possible explanation relies on the effects of uncertainty: a tariff shock creates (or coincides with) an uncertain economic environment, which by itself depresses economic activity by lowering consumers’ and investors’ confidence and puts downward pressures on inflation (Leduc and Liu, 2016). Another possible channel is a wealth channel, whereby an adverse tariff shock leads to a drop in asset prices, which then depresses aggregate demand and leads to higher unemployment and lower inflation. We find evidence in support of both channels: in response to higher tariffs, stock prices decline and stock market volatility increases.
The current economic situation today looks similar to the first scenario, where demand for goods and services is skittish as consumers, especially among low- and middle-income individuals, and investors feel uncertain about the future and are pulling back on spending.
Meanwhile, the inflation rate as measured by the consumer price index (CPI) has recently risen as unemployment has started to tick up, though it is still well within the 4%-4.3% range that it has been for the past year and a half.
Implications
Tariffs have long been viewed by conservatives and free-market advocates as the wrong solution because they drive prices higher. Milton Friedman once said, “Our tariffs hurt us as well as other countries.” However, President Trump has used tariff policy in both administrations as a tool for economic rebalancing and for foreign policy goals.
We are currently recovering from record-high inflation that drove prices up 20% overall due to massive federal spending, funded by money printing. Americans are very sensitive to price increases and believe that any rising inflation is due to the Liberation Day tariffs announced by President Trump in April 2020.
However, Federal Reserve Chairman Jerome Powell proved that it is not the case, saying recently
Higher tariffs have begun to push up prices in some categories of goods… but their overall effects on economic activity and inflation remain to be seen.
Using empirical data, researchers are now confirming what Powell and some of us have suspected for some time. Tariffs are not necessarily inflationary and aren’t driving up prices across the board. As the report concludes, on balance, prices actually fall over time.
That said, prices are not the only consideration in the economy. Tariffs drive up domestic unemployment, a consideration for policymakers, such as the Federal Reserve governors who determine interest rates. The Fed has a dual mandate to keep prices and unemployment low. If tariffs erode employment over time, they may look at these policies with suspicion and opposition.
Bottom Line
Tariffs are here to stay for now. In the long run, history tells us they will lead to lower prices across the board, even if it leads to more unemployed Americans. Is this a tradeoff Americans are willing to accept, though?