The Federal Reserve is Right

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According to multiple news sources, the Republican administration has recently considered removing Chairman Jerome Powell from his position at the Federal Reserve. This recent rise in tension between the government and the Federal Reserve stems from the idea that the Federal Reserve should lower interest rates in the US in order to stimulate the economy.1 The main disagreement between the Federal Reserve and the government revolves around the effects of tariffs on the economy and the appropriate response of a central bank. Let’s discuss why the Federal Reserve is right.

Tariffs and Inflation

The Federal Reserve is concerned that tariffs can result in higher inflation, while the government believes this is not true. The key argument made by tariffs advocates can be summarized in four points:2

1. Tariffs are not inflationary, because they are only one-off price increases.

2. Other prices will adjust to offset the increased cost of tariffed goods.

3. Economists wouldn’t say other taxes, like carbon taxes, are inflationary.

4. If we look at the recent inflation data, inflation hasn’t gone up.

Let’s unpack these points.

Regarding the first point, it is worth noting that even a one time upward shift in the overall price level is inflation. However, I understand that the focus of this statement is whether tariffs can lead to persistent inflation. To answer this question, we need a model. 

Modelling the Impact of Tariffs

Long-time followers of our newsletter are likely familiar with the New Keynesian model, which we have covered in great detail. This model serves as the primary framework utilized by central banks to understand inflation dynamics.

The main implications of this model are that inflation is directly related to the real marginal cost, where the real marginal cost is how much it costs to produce one more unit of an item in real terms.

Tariffs on intermediate goods like steel or raw materials directly impact the real marginal cost; these tariffs increase the