I managed to not notice a curling rock in my path when sweeping on Monday, so my writing plans this week were curtailed as I nurse my left knee. As such, I am stuck with following the herd on Bluesky. My consulting work schedule has still been intense, but I think it should slow down shortly, giving me more editing time for my manuscripts.
One of the current Bluesky points of discussion is whether tariffs are “inflationary,” a “one-time price shock,” or even a “relative price shift.” I think that if we do see a large universal tariff hike, it would qualify as “transitory inflation.” As we have seen, transitory inflation is no big deal politically.
Relative Price Shift
One argument made is that tariffs are just a relative price shock. (This is Treasury nominee Bessant’s argument that I have seen summarised, but I have not chased down his original argument.)
Although one might attempt to justify this argument by appealing to economic theory, I am skeptical about theory. I follow a strict definition of relative price shifts: the overall price level/aggregate inflation rate is unchanged, while different components of the price index go in different directions.
I view it as extremely unlikely that other prices would fall to match the price effect of a large universal tariff increase, so we would see an upward bump to the price level. Downward nominal rigidity in prices is a long-observed empirical reality (predating its “discovery” by New Keynesian economists). For example, I see no reason to believe that universities and landlords are going to drop their asking prices in response to a tariff hike. There is no doubt that there would be a relative price shift within the overall rise in prices (imported goods prices rise more than purely domestic ones), but that is not “just” a relative price shift. It is added colour to the inflation process.
The rest of this article assumes that my bias is correct. If not, whoopsie.
A One-Time Rise in the Price Level is Transitory Inflation
If the price level jumps and then remains either constant or on its previous inflationary path, we will see a temporary jump in inflation rates. The usual rate of inflation in discussion is the 12-month percentage change in prices. Under that definition, there will be an elevated (relative to trend) inflation rate for 12 months.
Although there was wrangling about the definition of “transitory” in recent years, there is no reasonable definition of “transitory” for which it cannot be applied to such an event.
The issue with transitory inflation is whether other forces conspire to make the jump in the price level somewhat less transitory.
I believe that one can dig through European and Japanese price indices to see examples of value-added tax (VAT) hikes causing one-month upward jumps in the price level. One might attempt to argue that a universal tariff hike would be similar. The problem with that argument is that tariffs do not hit all consumer goods like a VAT, it is targeted. There would be effects on the economy if actors adjust purchase behaviour based on price signals to any extent.
Attempts to substitute domestic goods for foreign-produced ones would tighten the “generalised (domestic) output gap,” which is normally assumed to create inflationary pressures. (I think the traditional definitions of “output gap” do not work, but it is hard to find economic schools of thought that do not accept that economies “overheat” and cause inflationary pressure. The only exceptions I can think of are simple-minded variants of the Quantity of Money theory. I use “generalised output gap” as a qualitative version of “overheating,” where I think it represents a bunch of economic variables rather than a single time series that could in principle be estimated via econometric means.)
Universal tariffs on Canada and Mexico (targets that any observant Canadian could easily have predicted) would be an excellent way to raise food prices. I am still amazed that this would even be thought about in the same month as an election that was probably decided by one-time jumps in foodstuff prices.
Tax Cuts Blow Up Economics 101 Tariff Analysis
The “Is a tariff hike a one-time price level shock?” debate is a silly Economics 101 debate in that there will be more than one thing going on in the economy. I see it as exceedingly unlikely that Trump will break from the historical trend of Republicans enacting massive tax cuts (that dwarf whatever cuts they make to welfare state spending and/or the dampening effect of the tariff tax haul). A “one-time” jump in the price level that puts domestic production capacity under pressure coupled with a fiscal push in an economy that has seen disappointing inflation performance is not a recipe to avoid second round effects.
If one is of a conventional persuasion, one might argue that inflation is determined by central bank policy settings. (I am in the camp that fiscal policy trumps monetary policy.) The Fed attempting to engineer a recession immediately after Trump taking power would be taking severe political risks. One might call to mind Stalin’s “The Pope! How many divisions has he got?” question.
Will Tariffs Happen?
I agree with Luke Kawa’s assessment that appears in “Three reasons why investors are brushing off Trump’s tariff threats.” He has a useful diagram of the Trump “Hot Air Cycle” where Trump’s policy ramblings hit the stock market (his preferred measure of economic vitality), which causes policy reversals.
Trump’s posting on social media hinted that concessions elsewhere (drugs and immigration) might forestall the tariff threat. (Yay, instead of Kremlinologists scrutinising who stands where at the May Day parade, we are scrutinising social media posts.) For countries that are not China, using tariffs as a political club is what I expect to happen, although I do not rule out universal tariffs showing up before they are withdrawal.
I doubt the political sustainability of tariff policy as a lame duck President is going to have a hard time keeping a coalition in the Republican Party together backing a policy that runs counter to the beliefs of many free marketeers. The fundamental problem with American foreign policy is that the decisionmakers are largely dilettantes that are only interested in American political struggles, while they face off against smaller countries facing existential threats and who are intimately familiar with the American political landscape. The only time that Americans had anything resembling foreign policy expertise at high levels was during the Cold War — and they had no idea what was happening in the domestic politics behind the Iron Curtain. As such, the expertise was relatively straightforward to grasp (more weapons is good — which dovetailed with domestic political concerns).
Concluding Remarks
What will happen during Trump’s term is largely guesswork. A large universal tariff on Canada and Mexico coupled with a tax cut is not a recipe for inflation bliss, but it remains to be seen whether the policy is politically sustainable.
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