Analyzing tariff effects on inflation.
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Inflation may be down to the Federal Reserve’s target, if we subtract the effect of tariffs. Perhaps, then, the Fed can bring down interest rates more. That’s an implication of research at Harvard Business School’s Pricing Lab. Their “data contain daily prices scraped from the online stores of large multichannel U.S. retailers.” They calculate duties on the products and find that so far, pass-through to consumers averages 20% of the tariff. (That will likely rise to 100% within a few years, in my judgment.)
Inflation Statistics
They compare the tariff-induced inflation to the overall Consumer Price Index: “This implies that the annual inflation rate in the CPI, which in August 2025 (latest available) stood at 2.9 percent (NSA, CPI-U), would have been instead about 2.2 percent without the tariffs.” Since that research, another month of CPI data showed about the same inflation rate.
The Federal Reserve targets the Personal Consumption Expenditures Price Index, which uses the same underlying raw data as the CPI but weights it differently to account for changes in consumer spending by category. That index averages about 0.4 percentage points lower than the CPI. So the Fed’s target translates to about 2.4% CPI inflation, and we would be at roughly 2.3% if not for tariffs.
I am doubtful that underlying inflation has truly dropped that low, though I have not performed the detailed analysis that the Pricing Lab did. The study contains assumptions and estimates that may turn out to be inaccurate. Disinflationary pressure has not seemed strong enough for that result, at least not in the first three quarters of 2025. But let’s assume the analysis is accurate, and let’s further assume that Federal Reserve staff come to the same conclusion. What can we expect for interest rates going forward?
Monetary Policy And Tariffs
Let’s begin with the question how the Fed should look at tariff-induced price increases. Consumers are actually paying higher prices because of the tariffs. The tariffs should certainly be counted in inflation, but the Fed should exclude them in deciding monetary policy. Ordinary inflation comes from excessive stimulus relative to the country’s productive capability. (Economists argue among themselves about the relative importance of fiscal policy and monetary policy, but most all agree that only excessive stimulus causes persistent inflation.)
Monetary policy can solve the problem of excessive stimulus. Tighter monetary growth and higher interest rates will slow discretionary spending by both consumers and businesses, damping inflationary pressure. But monetary policy cannot stop prices from rising due to tariffs. Tighter policy can cause less non-tariff inflation, so that the total inflation rate comes down to target. But that would be at a cost to employment and production, a cost there is no reason to bear.
The Federal Reserve has analyzed (p. 85ff) alternative policy responses to tariff-induced inflation. They concluded that “seeing through” the tariffs so that policy is set with regard to the underlying inflation estimate is the better course of action, given some assumptions. Fed chair Powell referenced that analysis earlier this year, so it’s still top-of-mind.
Inflation Expectations And Tariffs
One key assumption of the see-through policy is that inflation expectations remain “well anchored.” If the public views the higher total inflation as likely to be permanent, then tightening monetary policy, even at the cost of a recession, generates better long-run results.
For simple illustrations, we economists often describe tariffs as triggering one-time price hikes. However, the full effects of tariffs on the price lever may be gradual, spread over several years, even if they don’t push inflation up permanently.
Think of a foreign factory that sells products in the U.S. at a price that covers its costs and a market rate of return on capital. If it must cut prices to sell its products, the factory won’t cover its costs and return on capital. The factory will not continue producing for the U.S. market if it can must cut prices. But that is a long-term perspective.
When tariffs are first imposed, the company may have finished products ready to be shipped, without an alternative market that will take the goods. The company cuts prices by the full amount of the tariff rather than let the products sit on the shipping dock. American prices don’t change.
Should they produce more goods, selling at a partial discount? They have the factory, employees and they already have the raw materials on hand. Producing the product will require them to pay their workers and use electricity. If they have to cut their prices a lot, eating most but not all of the tariff cost, it still makes economic sense to manufacture the goods. American prices go up, but not by the full amount of the tariff.
What about ordering more raw materials? They can’t cut their prices as much as when they had already bought their raw materials. They won’t be earning enough to cover their cost of capital, but the capital is fixed—building and equipment—so that cost will continue even if production stops. American prices go up even more.
At some point, a machine will need to be replaced. It’s one thing to operate a machine the factory already owns; it’s another to lay out cash to replace the broken machine. In order to do that, they are unable to provide much tariff relief to their customers. American prices go up again.
In other words, ordinary microeconomic analysis argues for the pass through of tariffs into American prices to occur gradually, possibly over years. That could lead consumers and even business leaders to think that the long-term inflation rate is permanently higher. If so, the best monetary policy is to bring total inflation down to target as quickly as possible.
The Fed’s Interest Rate Choice
The Fed’s choice will not be easy. It seems likely that they will choose the see-through policy, easing interest rates because underlying inflation is at target and they believe current interest rates would lead to job declines. But when current conditions are hard to interpret, they will err on the side of not easing too much. The result will be policy that’s not quite than full see-through, but not as easy as it would be absent the tariffs. I expect interest rates to come down a little in the coming 12 months, but not as much as the Fed’s more dovish members want.