Tariffs are the mother of all cost shocks

The past week has witnessed the descent of the US economy to emerging economy status. With stocks and the dollar down and US borrowing costs up, America has experienced a mild version of a sudden stop. Luckily for the Federal Reserve, there is a New York Fed staff report kicking around with a playbook on what central banks should do in these circumstances: maintain credibility, allow the currency to float and accept that interest rates will initially have to be higher than otherwise.

That is exactly the message that has come from Fed officials. The New York Fed’s president called for a continuation of “modestly restrictive” monetary policy as inflation climbs towards 4 per cent. Susan Collins, president of the Boston Fed, highlighted the “foundational” importance of anchored inflation expectations in signifying “the credibility of the central bank, [which] is really an asset that’s earned over time”. Christopher Waller, a Fed governor, hedged his bets on Monday.

All this angst stems from Donald Trump’s tariffs, which all of the officials thought would raise prices. Opinions vary on exactly how much is to be expected because Trump’s tariffs can hardly be described as a settled economy policy strategy.

The difficulty in modelling Trump’s tariffs is best demonstrated with the effective US tariff estimates produced by two reputable institutions, the Budget Lab at Yale and the Tax Foundation.

The Yale analysis, based on patterns of imports from 2024, showed the pausing of “reciprocal” tariffs last week actually raised the effective US tariff rate from 22.5 per cent to 27 per cent. In contrast, the Tax Foundation’s work makes behavioural assumptions, slashing imports from China in the face of higher taxes. So the pause cut the effective US tariff rate on its calculations from 14.5 per cent on April 2 to 11.5 per cent on April 9.

The important point is that you do not have to choose between these analyses. This is a moment for rough-and-ready estimates rather than fine-tuned economic models. All these numbers are enormous compared with previous US tariff rates. People will not be chuffed.

Steep new tariff rates are bound to spoil what were looking like benign inflation trends in the US. Annual consumer price inflation dropped in March to 2.4 per cent from 2.8 per cent a month earlier. The FT core measure, which combines many other underlying inflation indicators in a statistically optimal way, also moderated.

These measures are now stale. The big question now is the degree to which new tariffs will show up in prices. It is important to note that the new rates are applied only to goods that were put on ships or aircraft after the tariffs were announced. So we are likely to see the effects first in perishable goods and later in consumer durables from Asia, which take around a month to reach the US.

The data to watch first is the import price figures from the Bureau of Labor Statistics, with March’s readings being published today. These show the price of goods arriving in the US before tariffs are applied. The administration would like to see these dropping, suggesting that other countries are paying. There is no sign of this yet. And just for fun, I have also shown the implied tariff-inclusive price.

There is very little doubt that, absent a complete Trump capitulation, this is the mother of all cost shocks for the US goods supply chain.

Cost-shock royalty

If Trump is the tariff king, the inflation of 2021-23 has elevated economist Isabella Weber to the position of cost-shock queen. Her explanation of inflation during and after the pandemic was that rising costs gave companies the power to raise prices, because normal forces of competition were replaced by implicit co-ordination between companies. Everyone blamed the rise in costs. She labelled this “sellers’ inflation”.

Her latest research uses comments gathered from earnings calls to show that chief executives were happy when input prices rose after Covid-19. Inflation followed upward. The paper is clear this is a correlation and not a causal analysis.

Although often said to be a view from the fringe, Weber’s thinking was essentially the same as the ultraorthodox Bank for International Settlements’ view that the pandemic caused a shift from a low-inflation world, where people could ignore prices, into a bad, high-inflation world, where they became central to everyday life.

What was genuinely controversial was Weber’s prescription for sellers’ inflation. She advocated for governments to hold buffer stocks of fundamental parts of the supply chain alongside price controls to stop the inflationary process. Since tariffs are a pretty pure cost shock, I got in touch with Weber last week to see what she thought about how to respond now.

“This is a massive, massive cost shock,” she told me. But she said it was not a pure test of her theories because tariffs would also hit demand, so predictions were difficult.

With this caveat in mind, she said the huge China tariffs could easily cause shortages of certain items where substitutes were difficult to find. “In this kind of situation, the power to set prices is much larger than if it’s just the implicit co-ordination from a cost shock.” 

Interestingly, she added that this was not a moment for buffer stocks or price controls because the cost increases were not limited to a few significant inputs such as food or energy.

“Tariffs are not a local price explosion, right? This is not the price of oil, shipping or grain shooting up. They touch literally every sector.”

So, what is Weber’s policy advice? End the tariffs.

“This is a policy-engineered inferno and the question is really how to stop the inferno.”

It only goes to show that however tempted you might be to look for rational theories explaining Trump’s tariffs . . . 

Stop.

Economists of all persuasions, who were at each other’s throats over the recent inflation, think his tariffs are terrible policy and defy rational explanation.

What I’ve been reading and watching

If you think the US holds all the cards because it imports more from China than it exports, think again says Peterson Institute chief Adam Posen in this Foreign Affairs article. Beijing can escalate tariffs more than the US because it has only money to lose. Trump’s capitulations so far suggest Posen is right.

The Argentine central bank is lifting exchange controls as part of a fresh $20bn loan from the IMF. The fund cannot afford this programme to fail now. Lucky Argentina.

The Fed will be extremely reluctant to step in to calm markets for fear that it looks like a declaration of war against the administration. Susan Collins, Boston Fed president, tells the FT that it has the tools if it must. Full transcript on the FT’s Monetary Policy Radar.

Even though the dollar is slumping, China is letting the renminbi fall faster.

Senior trade writer Alan Beattie, US markets editor Kate Duguid and chief foreign affairs commentator Gideon Rachman will answer questions in a live Q&A tomorrow on how Trump has changed the world order here.

A chart that matters

When the US goes a bit loopy, it is important to remember that its importance to the global economy is in long-term decline. How much? Well, that depends on how you measure different countries’ weights. And that depends on the question you are asking.

If you want to talk about volumes of goods and services or raw power, use purchasing power parities, which is an estimate of what money buys. China does not pay for its army in US dollars, for example, so this is the right measure for military might.

On this measure, the US’s share has fallen from well over 20 per cent of the global economy to below 15 per cent. Americans, you’re just not that important any longer.

For trade, market exchange rates matter, and the ups and downs of the US share of world GDP depends almost entirely on the strength of the dollar. I would add the dollar has fallen 9 per cent since Trump’s inauguration day.