Comments and Response: Inflation, Tariffs, and Currencies

Yesterday’s column got a lot more response than I expected. Thank you. I always enjoy the comments and responses. I try to reply to them all by email as long as there aren’t too many. If you comment online, I try to answer them online as well.

In any case, two comments really caught my attention. I thought I’d share and use them to address a few other issues that might be of interest to other readers as well.

Here was yesterday’s column in case anyone missed it…

Interestingly, both comments felt the effects of the tariffs on the CPI will be less than people currently expect.

Comment 1: Tariffs Will Get Rescinded Before Their Impact Materializes

This first comment, from a student of mine who is quite intelligent and had long tariff discussions with me this Spring, was essentially this: the tariffs are slow to affect the economy, they keep getting delayed so we see even more importing and stocking up, and this further delays their full effects on prices. And, the government will rescind the tariffs before too long, either by choice or by court order.

The first part is in line with my comments. The effects are slow to work their way through the economy and are being further diluted today by delays.

The second part is a political or legal comment. I’m not an expert on that. My current understanding is that the tariffs were blocked by the U.S. Court on International Trade on May 28th but then a higher court, U.S. Court of Appeals for the Federal Circuit, stayed that block pending further review. A lot of the debate seems to be around the President’s ability to impose widespread tariffs is based on his use of the 1977 International Emergency Economic Powers Act.

Your guess is as good as mine concerning how all that plays out. For now, for analytical purposes, I’m assuming that the tariffs will survive the courts.

Comment 2: Tariffs Will Have Relative Price Effects, Not Aggregate Ones

The second comment comes from my friend Les Rubin of Main Street Economics fame who is truly a deep economic thinker. His insight is essentially this: Tariffs will hit some goods and raise their prices. But, this means consumers will have less income left over and therefore decrease demand for other goods, lowering their prices. Since some prices rise and some fall, the CPI, which is literally a (weighted) average of all prices, may not move at all.

He has since sent me further and good comments regarding where the tariff revenue goes, its effect on government deficits and aggregate demand. All excellent insights but won’t affect my column today. Thank you Les!

This is an excellent insight and we should take it seriously. It is one of the many reasons that I feel the effects of tariffs on the CPI will be mixed, harder to see immediately and certainly not have as clear effects as many commentators expect. But, in the end, I do think the most likely effect will be a higher CPI and lower productivity. Let me turn to addressing my friend’s insight and also explain my view.

As stated, the answer to whether some rising and some falling prices will average out to an increase or a decrease is a mathematical question and would depend on relative elasticities of supply and demand in each market affected. At best you could argue that it’s an open question as to whether the CPI moves at all and, if so, in which direction.

It is likely, however, that the net effect on just consumer final good prices is positive (i.e., raises the CPI) because the higher tariff price will reduce the quantity demanded of each of those items. Consumers will not consume the goods in the same quantities as they do now. How much they cut back is an empirical question¹.

That cut back in consumption frees up consumer budgets for other goods. Suppose I have $100 dollars and I spend 100% of it every week in the store buying 10 goods. To keep numbers simple, let’s assume that exactly half the goods increase in price due to tariffs and I cannot, therefore, financially afford to buy 10 goods anymore. This is part of Les’ point.

But, there is no reason to assume I buy the same 5 tariffed goods and reduce demand for the other, non-tariffed goods. Rather, I likely buy a little less of the tariffed good because it’s more expensive now.

For simplicity’s sake, again, let’s assume I used to spend exactly $50 on 5 tariff-goods and $50 on 5 non-tariff goods. There are two cases we might consider.

1. Case 1 would be that tariffs raise the prices of those 5 goods so that now I can only buy 4 of them but still pay $50 total and then continue buying the other 5 goods as before. In this case, half the prices rose and half remain unchanged. If this is true everywhere, the average of the prices, the CPI, would rise.

2. Case 2 would be that the tariffed-good prices rise some but not as much. I still can’t afford all 5 of them so I still buy 4 of them, but for, say, $45, freeing up $5 for me to try to spend on the non-tariffed goods, thus raising demand for them. Now, half the prices rise due to tariffs (though not as much as in Case 1) and the other half rise modestly due to higher demand. All prices rose some and thus the average, the CPI, should rise.

In my opinion, Case 2 is the most likely. People generally move out of expensive goods and into less expensive ones. I see no reason for it to be different today.

Now, to Les’ excellent point, this does mean that the CPI effect won’t be as dramatic as many are expecting. If tariffs rise on average by 30%, I don’t believe we will see the CPI rise by 30%, not even for the tariffed-goods themselves. They can’t all be perfectly inelastic goods (i.e., they can’t all be true, pure necessities).

Notice that in both cases, we are all made worse off. Pre-tariffs, in this example, I was buying 10 goods for $100. Post-tariffs, in this example, I am buying 9 goods for $100. Assuming that I value all those goods the same, I am definitely made worse off by the tariffs. This is generally the case in reality as well, not just in my example.

Consumer Goods Versus Production Inputs

I’ll add that in my above example we were just looking at final consumer goods. I would actually be a little less concerned about tariffs if they only affected final consumer goods. It would have all the effects just discussed in my example and we’d be worse off, but we wouldn’t have the negative productivity and other supply-side effects.

The Trump tariffs are across the board, however, and that means they hit inputs to business as well as final goods. We already discussed the final goods. You can imagine Case 1 or 2, whichever you like. For consumer goods there’s a lot of substitutability. If the price of an apple rises, I buy a banana instead. That’s not the case with many inputs to production.

The broader macroeconomic problem comes from the supply-side effects. With broad tariffs, the costs of production for a number of industries will rise. They can’t generally buy the same input for less from another source. If they could, they would already have done so. Actually, the global supply chains that industries developed over the past 50 years were based precisely on businesses seeking the lowest-cost, similar quality inputs.

As tariffs hit these inputs, it will raise the costs of production in the USA. We will then be able to produce less goods for the same cost or produce the same number of goods for more cost. Those both, by definition, represent a decrease in productivity in the United States².

This is the fundamental problem with the tariffs. Less efficient production which lowers everyone’s standard of living. We saw this in the $100 example in the grocery store. In the end, people will have to buy less for the same money. Everyone is worse off.

On the production side, the tariffs will reduce the supply of goods and services in the United States and, all else equal, that will also mean the same money chasing fewer goods and hence slightly higher prices on average. In other words, it should mean a higher CPI.

Rather than cause too much alarm, if the tariff effects are too widespread and hit too many industries, the drop in supply will be relatively mild. It might mean that instead of supply growing 3% a year it grows 2% a year or maybe it only shaves a half percentage point. It’s hard to know. But these things add up and dramatically so over time.

European productivity and GDP are a good warning.

In 2008 the European Union’s GDP per capita was about 76.5% of the US’s. Due to a slowdown in European productivity, today the European Union’s GDP per capita is about half of the US’s (numbers from: link). Productivity matters a lot over time.

If the US economy grows at 3% a year, it will double in size in about 23 years but if it only grows 2% then it doubles in 35 years. Go from 2% to 1.5% and it now takes 47 years. That’s a huge impact on human well being. The effects of productivity, or the lack thereof, add up quickly over time.

Conclusion and Final Comments

Both these comments were relevant, and I hope them and my responses were helpful. Just to be clear, both comments add to my point about it being difficult to see the tariff effects in the CPI number. It’s noisy.

Tariffs don’t happen in a vacuum. But, with large and across the board tariffs, the effects should show up sooner or later. They will be very strong for some industries, less so for others, but will be there nonetheless and should raise the CPI and worsen productivity. Both of those effects will make us all a little worse off.

Overall, total imports are about 14% of US GDP. It looks like imports of final consumption goods are only about 3.4% of GDP (link to FRED). That means most of the 14% of GDP is imports of “intermediate goods” which are inputs to industries. So the supply/productivity effects will be the bigger effects from tariffs since most imports are of inputs to businesses. This is a negative supply shock to the economy.

My original view remains unchanged. I really appreciate the comments and I hope my column today provides insights for people, but I think…

1. we will see some effects on prices of goods,

2. it will take longer to work through the system than most people expect,

3. the on-and-off policy will further delay the effects, but

4. the effects will materialize and raise the CPI over time.

Sadly, I’m 100% sure that the tariffs will lower American productivity and well-being.

Thank you for reading.

1. How much consumers cut back when prices rise is called “elasticity of demand”. Think of elastic like a rubber band. An elastic rubber band stretches a lot when pulled. Similarly, a good that has “elastic demand” for it will lose a lot of consumers when the price rises a little. Luxury goods are typical examples. A small increase in price can lose a lot of customers. By way of comparison, heart medication generally has less elastic demand since it’s needed no matter the price. Raise the price some and people still buy (mostly) the same amount so very little sales are lost.

2. More productivity in economics is anything allowing you to do more with the same input. It’s in line with common sense: you say you had a productive day at work when you got more done in the same 8-hour work day. Same input (8 hours of labor), more output. In general this can come from simply organizing your time better or from some other technology like a computer, but the fundamental is the same: more output for the same input.