By Michael Metcalfe, Head of Macro Strategy, State Street Global Markets
The assumption that the imposition of US tariffs will be inflationary is a keystone of many so-called Trump trades, from short Treasuries to overweight USD. But it should not be taken as a given. We consider three different studies, two from the Fed and one from PriceStats co-founder Alberto Cavallo, that show the potential pass-through to consumer prices, and therefore policy implications, are more complex. A recession rather than inflation may be more likely. This time could, of course, be different. The broader economic environment in 2025 creates potentially more vulnerability to inflation than during the first wave of tariffs in 2018/19, a tendency that could be exacerbated by easier fiscal policy and changes to immigration. Nevertheless, taking the lessons from the different papers discussed here, we will propose a mix of alternative, official, and market data to form a watchlist for 2025 that can be used to gauge whether we should be more worried about the return of inflation as current market pricing seems to imply.
Just passing through?
In Tariffs from the border to the store , Alberto Cavallo and his co-authors use a mix of customs and PriceStats goods-level data to directly measure the pass-through, or not, of Trump’s original tariffs in 2018. This detailed micro-level study comes with some significant macro take-aways.
At the border, it was clear that the bulk of the first wave of tariffs in 2018 was passed through to US importers. The cost was not borne by Chinese exporters lowering their prices. For an average good, a 20% tariff would be associated with exporters lowering their prices by only 1.1%, leaving 18.9% of the increase to be paid by the US importer. Curiously, the impact of retaliatory tariffs hit US exporters more directly but we will come back to this point later.
The impact in the store on consumer prices, in contrast, varied significantly. While there was pass-through to end consumer prices in goods where tariffs were very high (washing machines, for example), that was not the case for goods where tariffs were 20% or less. In these cases, for goods such as hand bags, bicycles, refrigerators, and many more, the impact on consumer prices was barely discernible.
The authors conclude from this that the size and the question of the potential longevity of the tariffs likely played a role in US retailers’ decision to absorb the tariffs through reduced margins. 2025 could be different in both regards, of course. Nevertheless, how both exporters to the US and US retailers responded in 2018/19 points to some caution on pass-through to inflation.
These findings echo a much older report from the New York Fed by Campa and Goldberg on exchange rate pass-through, which highlighted the importance of retail and distribution margins in almost eliminating exchange rate pass-through from import prices into CPI.
Just how much?
Directly related to the question of margin and pass-through is just how much US consumers actually spend on imports. This was nicely detailed in the San Francisco Fed’s Economic Letter at the beginning of 2019. Their paper not only looks at spending on imports directly, but also considers the local content in the final price of imports as well as the imported content of goods ‘Made in the USA.’ Both can be quite significant, to the point about US retailer margins noted in the first paper. The authors quote an example of a USD100 pair of sneakers made in Asia, USD75 of which accrues to
US business, USD50 of which are US retailers and logistics. Putting it all together, they take the total amount spent on final goods produced abroad, subtract the local content that is embedded in the price of these goods, and then add back in the import content of US-made goods. The detail can be seen here, but is summarised in Figures 1 and 2. 6.4% of US consumer spending goes toward imported goods, split almost equally between durables and non-durables, while 4% goes toward imported services (two-thirds of which comes from the imported content of some services). Additionally, given the likelihood of higher tariffs on goods coming from China, 1.7% of 10.7% spent on imports come from China (either directly or through intermediate goods).
Adding this to the original question of much of tariff hike makes it through to consumer prices, this highlights the relatively modest share of consumption it potentially impacts.
Just looking through
Our third study comes from the staff of the Fed’s Board of Governors and their top-down macro scenario analysis in Tealbook A, September 2018 (federalreserve.gov). As background, the Tealbook provides in-depth analysis by the staff for the FOMC not only on current economic conditions, but also on various scenarios that may impact the outlook. Along with the transcripts of the meetings, the reports are released with a five-year lag.
The September 2018 edition is especially relevant today because the Fed staff modelled the impact of a 15% universal tariff on all non-oil imported goods, alongside a similar-sized increase in on US exports. Noting that there were few historical precedents and that there was unusually large uncertainty around estimates, they modelled two scenarios; one in which the Fed responds by raising interest rates and other where the Fed “sees through” the short-lived rise in inflation.
The results for inflation and growth are summarized in Figures 3 and 4 (they can be fully seen on page 84 of the Tealbook itself). The main takeaways, to borrow a term from 2022, is that the inflation generated by a universal tariff in the Fed’s macro model is transitory. Against their original baseline forecast, the 2019 projection for core PCE is 0.6%-0.7% higher (Figure 3). But PCE projections for 2020 were actually lower due largely to the impact on growth or assumed policy tightening. As Figure 4 shows, the combined impact of the tariffs and tightening reduced the Fed’s assumed growth rate substantially and actually tipped the economy into recession in 2019. Even without the impact of policy tightening, the growth forecast is reduced substantially.
In a similar vein to Alberto Cavallo’s more micro paper, there may be assumptions here about the price elasticity of US exports, especially those to China, which are mostly substitutable foodstuffs. But the Fed staff also assume that productivity growth slows in the face of a reduction in international competition. Altogether though, the Fed modelling in 2018 sent a relatively clear message, albeit couched in large error bands: tariffs would weigh on US growth, generate a transitory impact on inflation, and likely should not elicit an interest rate response.
Seven years later and tracking 2025
Taking all three papers together casts considerable doubt on how much inflation tariffs on their own may generate. Outside of goods from China, there is potential for a sizeable share of the tariffs to be absorbed into US retailer or distributor margins. For what does get passed through, imported goods (net) account for just over 6% of all US consumption spending (which also determines the weight of the price impact on PCE). Even then, as the Fed’s estimates in 2018 demonstrate, the addition to inflation is unlikely to last and there could also be an offsetting hit to growth. All of this suggests the impact from tariffs on consumer inflation may not be as troubling as many appear to assume.
There are, of course, some important potential caveats to this. In particular whether the economic and political environment in 2025 is different. As we detail in Figures 5 and 6, the Fed’s current growth and unemployment rate projections today are actually not too dissimilar to 2018’s. The growth profile is similar and forecasts for the unemployment rate are actually higher. So top-down, the environment viewed through growth and the labour market looks more benign, although the labour market outlook today is likely to be complicated by potential changes to immigration policy.
The same cannot be said for current inflation, though, which is arguably the most important variable here. The starting point for Fed’s core PCE forecast today is a full percentage point higher than their 2018 scenario for example. This more recent inflation mindset may persuade US retailers to pass on higher import prices more thoroughly than they did before. There may also be a sense that 2025 tariffs, when they come, may be more permanent and in some cases larger than what we saw in 2018, especially in the case of China. Obviously we will need the detail of the tariff policy to asses this more clearly. It may be stepped to mitigate the immediate impact on inflation, the threat of future tariff moves may be used to secure better trade deals or promote US companies to onshore component production. All of these will remain unknowns. What we do know, however, thanks to the insights from these papers, is that we will be able to use a combination of PriceStats and a handful of official data readings to get a real-time read on whether the implementation or even the threat of tariffs is having a different impact on inflation in 2025.
The original New York Fed paper by Campa and Goldberg cited earlier highlighted a range of sectors that had both high import components and high local distribution margins. Furniture and other manufactured goods, for example, had on average 43% imported inputs as well as an average distribution margin of 27%. Various apparel categories also had similar import content. This makes these core categories good candidates for the theory that tariffs may only partially pass through into consumer prices and hit margins instead.
We will be able to track retailers’ decisions in these sectors in near real-time with PriceStats sector series. As shown in Figure 7, the annual inflation rates in the sectors noted above are close to long-run averages, although furnishings have shown some firm months of price formation over the summer. In a more aggregate way, we will also be able to track the relative prices of US goods relative to their major trading partners (a component of PriceStats PPP calculations – Figure 8). Given this is based on a matched basket of identical tradeable goods, it could also capture relative tariff pass-through. We can then combine these series with official data such as the trade services component of the PPI, which also attempts to capture retail margins.
In a similar vein to our ten tests of transitory inflation, and the ten tests of inflation normality, we will combine these focussed PriceStats metrics with a range of official, alternative, and market data: the aforementioned trade services component of the PPI, job postings from Indeed in industries or states where there are the greatest risks to labour supply from changing immigration policy, and, as ever, the role of investors’, consumers’ and economists’ expectations.
Together, these new aggregate measures should enable us to capture whether 2025’s tariffs will prove as benign in their impact on price pressures as some of the studies discussed in this piece suggest. They may well have changed, but the Fed’s own models suggested a recession was the more likely outcome of a universal tariff, rather than any lasting impact on inflation.
