Tariffs Are Not An Inflation Risk
Inflation is a general increase in the prices of goods and services. Changes in inflation are a function of fluctuations in actual demand for goods and services (also known as demand shocks, including changes in fiscal or monetary policy or recession), changes in available supplies such as during energy crises (also known as supply shocks), or changes in inflation expectations, which may be self-fulfilling. Note that supply and demand are key facets of the inflation equation. In 2020, inflation was the consequence of restricting supply and massively increasing demand. That massive surge in stimulus sent directly to households resulted in an unprecedented spike in “savings,” creating artificial demand. I understand the basic assumption that if you impose a tax on a product, good, or service, then the “cost” of that product, good, or service will increase, hence the inflation risk. While that is perfectly logical, it excludes two crucial factors: 1) Only producers pay the “tax” from tariffs, and 2) we measure inflation (in terms of CPI) from the consumer side of the equation. Corporations react to cost increases in their business (i.e., wages, benefits, commodities, utilities, etc.), which must be factored into the selling price to maintain profitability. Crucially, corporations can only pass on higher input costs to consumers if demand remains higher than the available supply of those goods or services. In 2020 and 2021, they could. However, as excess savings run out, inflation declines as consumers decrease spending; corporate profits weaken as the ability to pass on higher input costs to customers fades. Today, inflation is declining due to declining demand. As such, the percentage of cost increases corporations must absorb is increasing, which reduces corporate profitability but shows up in the economy as slowing inflation. As we should expect, consumer actions, which is how we measure inflation through the consumer price index (CPI), drive inflation risk. Consumer confidence is the key to understanding whether inflation risk is present in the economy. Despite all the commentary about tariff-related inflation risk, inflation is hard to achieve if consumers are unwilling or, more importantly, unable to pay higher prices. The bottom line is that inflation risks are extremely muted given the slowing economic backdrop and disruption in the stock and bond markets, which also impact consumer confidence. Could that change? Yes, but such a change would require a reinstatement of stimulus checks, a surge in Government spending, and the Federal Reserve increasing monetary policy. For now, none of those are available.
