The Trump administration’s Liberation Day tariffs were set to fully kick in on July 9, but the new duties on imported goods have been given another pause until August 1. While uncertainty looms large over trade policy, so too do a pair of fundamental economic questions: Are tariffs inflationary? And should the Fed do anything about it?
Following the Federal Open Market Committee’s decision last month to keep holding interest rates steady, some commentators accused Federal Reserve Chair Jerome Powell of playing politics by not cutting rates. Powell acknowledged that monetary policy was moderately tight and that a more neutral policy stance would be warranted “if you just look backward at the data.” He noted, however, that the FOMC must be forward-looking. Given the tariffs recently imposed and those currently undergoing further consideration, “the thing every forecaster — every outside forecaster and the Fed is saying is that we expect a meaningful amount of inflation to arrive in coming months and we have to take that into account,” he said.
Oren Cass — a leading advocate of President Trump’s tariff agenda — disagrees. He has argued that tariffs are not inflationary and therefore lie outside the Fed’s mandate. Cass described the FOMC’s vote to hold the federal funds rate target above neutral as “a nakedly political decision intended to frustrate the policy choices of elected leaders.”
Much of the debate over whether tariffs are inflationary has focused on their effect on the price level. There seems to be broad agreement that higher tariffs lead to a one-time increase in the price level, not a sustained rise in the rate of price increases, that is, inflation. If it takes time for tariffs to pass through to consumer prices, inflation may temporarily pick up — a point Fed officials have acknowledged. But once the adjustment is complete, the inflation rate will come back down — that is, the increases will stop, even if prices themselves remain at a new, higher level.
Is this consensus view correct? It’s certainly possible that tariffs result in only a one-time jump in the price level without causing sustained inflation. But that outcome isn’t automatic. It depends on how tariffs affect the underlying drivers of economic growth — and whether those effects are large enough to push inflation higher, justifying a policy response by the Fed.
Understanding Inflation: A Framework
To assess whether tariffs are inflationary and whether the Fed should act, it can help to have a simple framework for understanding inflation’s underlying causes.
For starters, let us note that there are two sides of every transaction: the spending side and the income side. These must be equal, since every dollar spent by one person becomes income for someone else. It follows then that any change in the growth rate of dollar spending must be matched, one-for-one, by a change in the growth rate of dollar income. For example, if total dollar spending rises by 10 percent, total dollar income must rise by 10 percent, as well.
We can break dollar spending growth and dollar income growth into their constituent parts. Spending growth equals the growth rate of the money supply — controlled by the Fed — plus the growth rate of velocity, which measures how quickly dollars circulate through the economy. Income growth equals the inflation rate plus the growth rate of real (inflation-adjusted) output — that is, output measured in constant prices to separate true increases in production from mere increases in prices.
Formally, we can express this relationship as:
Money Supply Growth + Velocity Growth = Inflation + Real Output Growth
Economists refer to this relationship as the equation of exchange. We can rearrange the equation of exchange to focus on inflation:
Inflation = Money Supply Growth + Velocity Growth − Real Output Growth
This formulation, which I will call the inflation equation, makes accounting for inflation straightforward: inflation rises when (1) money growth or velocity growth rises or (2) real output growth falls.
The question, then, is how do tariffs affect the components of the inflation equation? We will look first at real output, then money velocity growth, and lastly at money supply growth and the Fed (since the Fed is in charge of the US money supply).
How Tariffs Affect Inflation: Output Growth
Tariffs are likely to reduce productivity by raising input costs and limiting access to more efficient foreign suppliers, and to distort resource allocation by encouraging production in less competitive domestic industries — both of which can lead to slower real output growth. In this sense, tariffs could be mildly inflationary if they reduce real output growth while spending continues at the same pace. But any effect on output growth is likely to be small — for example the FOMC’s projection of long-run real GDP growth has not changed since December 2019, and only then from 1.9 percent to 1.8 percent — meaning the resulting increase in inflation would also be small, given the one-to-one relationship between real output growth and inflation in the inflation equation.
How Tariffs Affect Inflation: Money Velocity
What about velocity? How quickly people spend money depends, in part, on the opportunity cost of holding it. Economists typically measure this cost by the interest that could be earned by holding wealth in assets that yield a higher return than money. When interest rates rise, the opportunity cost of holding money increases, so people tend to spend dollars more quickly. When interest rates fall, the cost declines, and people are more willing to hold money.
Interest rates are mildly procyclical, meaning they tend to rise when the economy is growing and fall during slowdowns. This is partly because technological progress boosts business investment, increasing the demand for capital — while weaker productivity growth has the opposite effect. If tariffs reduce real output growth, they are also likely to put downward pressure on interest rates by dampening investment demand. Lower interest rates reduce velocity by making it less costly to hold money, which could offset some of the inflationary pressure from slower real output growth. Unless interest rates continue falling over time, however, the growth rate of velocity is unlikely to change much. In short, if tariffs are inflationary in the sense of permanently raising the inflation rate, they are only mildly so.
How Tariffs Affect Inflation: Money Supply and the Fed
Now recall the third part of our equation of inflation: the money supply, which the Fed controls. If tariffs are pushing up prices — whether by slowing real output growth or reducing the velocity of money — should the Fed respond by changing the money supply?
If the Fed is committed to hitting its inflation target, regardless of where price pressures come from, then it might feel compelled to tighten policy. That would mean raising interest rates above the neutral level to slow money supply growth and counter the inflationary effects of the tariffs.
But here’s the dilemma: Tariff-driven inflation stems from a supply-side shock. Prices are rising not because people are demanding more goods and thus pushing prices higher, which can and sometimes should be offset by tightening the money supply. Prices are rising because the economy is producing less than it otherwise would. Changing the money supply cannot fix the problem of the economy producing less. Therefore, while tightening policy might lower inflation, it only does so by temporarily reducing real output growth even further.
Whether the Fed should act depends on how persistent the supply shock is — and how strictly it interprets its inflation target, given that a monetary response comes with real, if temporary, economic costs.
What to Make of It All
Overall, the inflationary effects of tariffs are likely to be small. Even if tariffs were to reduce real output growth by half a percentage point, which is probably an overestimate, the resulting increase in inflation would be half a percentage point or less, since the decline in velocity mitigates the inflationary effects associated with the decline in real output growth. Technically speaking, Oren Cass is mistaken: if tariffs reduce real output growth, they are inflationary. But his broader point stands: since the effect on inflation is likely to be trivial, the case for tighter monetary policy is weak at best.
Tariffs can be inflationary — even on their own — if they reduce real output growth. But the size of the effect matters. The output losses from tariffs are likely to be small, and so too are their inflationary consequences. The key is not whether tariffs can raise inflation — they can — but whether they do so by enough to matter for monetary policy to change the stance of the money supply. On that point, the answer is: probably not.
