Tariffs poised to re-ignite U.S. inflation

• The current tariffs could result in U.S. inflation rising by 1.4 percentage points.

• The ECB has responded to Trump’s tariffs by lowering rates, which goes against the administration goals of a weaker dollar and a smaller trade deficit.

• The dollar is flat over the past five years and down by only 4% in six months.

Jerome Powell is right to worry about the contradictory effect that Trump’s tariffs will have on the Fed’s dual mandate to maintain price stability and support growth.

Digging into the numbers shows a much larger tariff pass-through to overall U.S. price levels than the Trump team has let on.

A lot of the potential tariff-inflation havoc has to do with elasticities. Let’s dive in.

ε: price elasticity of import demand

The Trump administration explains that it estimates the U.S.’s price elasticity of import demand, ε , to be -4.

If true, this would mean that U.S. import demand is highly elastic, i.e. highly sensitive to prices.

In other words, the U.S. Trade Representative is claiming that for each percentage increase in the price of imports, there will be a four-fold percentage decrease in the volume of imports.

The problem with using ε = -4 is that there is no evidence to back it up. The literature (-0.92) and recent estimates (-1.01) suggest much lower import demand elasticity, of around -1.

There could well be higher import demand demand elasticities in some sub-sectors where substitute goods are readily available.

But, by and large, we shouldn’t expect demand to drop off more than the increases in price level.

If this doesn’t scare you, it should.

If ε = -1 is correct and if the administration sticks with its astronomically-high tariffs, U.S. importers and consumers are in for a rough ride.

φ: elasticity of import prices with respect to tariffs

The USTR goes on to claim that the elasticity of import prices with respect to tariffs, φ, is 0.25, citing work by Harvard economist Alberto Cavallo.

A low number like 0.25 represents the idea that import prices aren’t very responsive to tariffs.

By claiming this number, the administration is arguing that, for example, its 10% baseline levy on Australia will only lead to a 2.5% price increase in affected imports.

Yet Cavallo’s paper, and Cavallo himself, indicate that, actually, φ = 0.945.

As such, import prices appear set to rise more or less in tandem with tariff rates, meaning that the administration is grossly underestimating (mistakenly? purposefully?) the amount of pain it is about to inflict on U.S. consumers.

What will the impact be on prices?

These are static calculations and don’t incorporate changed dynamics resulting from the tariffs on other variables, such as exchange rates. The real-world effects will be different, but this back-of-the-envelope approach can at least give us the direction of travel.

The estimated trade-weighted average tariff rate for the U.S. has surged from 2.2% pre-2025 to around 22% currently, for an overall rise of 19.8%.

• P = the import price level

• τ = tariff rate increase

• φ = elasticity of import prices with respect to tariffs

• ε = price elasticity of import demand

Clearly, the administration is projecting a much smaller price impact of +5% compared to consensus academic research that suggests a whopping 18.7%.

Imports comprise only 7-10% of Personal Consumption Expenditures basket, which is the Fed’s preferred inflation measure.

Taking the mid-point as an ex-ante weight of imports in PCE, i.e. 8.5%, and, adjusting downward for the change in import volumes, gives a baseline from which to calculate the pass-through of tariffs to overall inflation.

Piecing together these threads of academic research thus suggests that Trump’s tariffs, as they currently stand, could result in U.S. inflation rising by about 1.4 percentage points more than if there had been no tariffs.

This number is startling and, if borne out, would result in strong pressure on the Fed to raise rates.

Even the Trump-aligned calculation suggests PCE to increase by 0.3 percentage points, which is also material to monetary policy.

The usual caveat applies: this isn’t a dynamic, general equilibrium model that would account for other factors like growth, exchange rates, or responses from consumers, businesses, and the U.S.’s trading partners.

The ECB Strikes Back

The economic policy insanity occurring in Washington is scarcely believable, but it has caused an abrupt change in the European Central Bank’s monetary policy stance.

The ECB decreased rates this week in response to tariff-related growth concerns. In doing so, Governor Lagarde admitted that most of the voting committee had been poised to keep rates on hold as recently as a few weeks ago.

So we’re seeing a new equilibrium, and one that goes against Trump’s desire to close U.S. trade deficits.

Lower rates in the Eurozone compared to U.S. rates weaken the euro compared to the dollar, all else equal.

And a cheaper euro means more European exports to the U.S., and more of a U.S. trade deficit (with the usual ceteris paribus caveat).

This goes against Trump’s stated goals of weakening the dollar and closing the U.S. trade deficit.

Rotation, not collapse

The dollar, however, has weakened significantly, but not for the reasons Trump intended.

Last week’s U.S. Treasury market selloff amid equities and USD weakening marked the desecration of their safe-haven status.

There has clearly been a rotation away from U.S. assets - equities particularly - this April.

However, the spike in U.S. Treasury yields - especially at longer maturities - seems to have been driven more by hedge funds unwinding leveraged positions than by foreigners fleeing en masse.

Moreover, even if the dollar is down 8.5% year-to-date, there has hardly been a collapse.

The broad dollar index is essentially flat over the past five years, and has dropped by less than 4% over the last six month window.

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