Cushion or pushin'

Summary

There are a number of ways in which the inflationary impact of the newly implemented tariffs on consumer prices may be cushioned. How well-positioned are these mechanisms to absorb the inflationary shocks of tariffs today relative to the 2018–2019 trade war, and what does that mean for the eventual pass-through to consumer price inflation?

Exchange rates and foreign factors: The state of the dollar and global capacity utilization garners slightly more optimism that the cost of tariffs could be partially shouldered by foreign firms this go-around.

The ability for a stronger U.S. dollar to mechanically offset the inflationary impulse of tariffs is limited by the vast majority (95%) of imports being invoiced in dollars. Rather, foreign firms need to actively adjust their prices lower to help cover additional costs generated by tariffs. But our expectations for a prolonged period of dollar strength and more excess manufacturing capacity among a number of key trading partners relative to the late 2010s could assist in a somewhat lower pass-through rate at the border.

US profit margins: Margins in goods-related industries are higher than in the 2010s, giving more room for firms to absorb tariff-related cost increases. But firms may be reluctant to reduce margins given that they are down relative to the more recent memory of a few years ago.

While in the previous trade war firms absorbed a material portion of tariff costs by reducing margins, underlying demand and price-setting dynamics have changed since the pandemic. We see risk that firms will more readily try to push price increases through. The industries most exposed to tariffs are not those that experienced the greatest cumulative price growth in the recent inflationary episode, perhaps limiting the degree to which inflation-fatigued consumers push back on tariff pass-through.

Supply-chain adjustments: The broad nature of today's tariffs and scrutiny of tariff workarounds like the de minimis exemption point to more difficulty evading longer-run tariff costs.

In the near term, evidence of more significant front-running of tariffs compared to 2018 is likely to help insulate the effect of higher import duties on consumer price inflation. Yet the wider net of countries being targeted means side-stepping tariffs for an extended period through the rerouting shipments and relocating production will be more challenging.

Our models point to a 0.6 percentage point increase in the year-over-year rate of consumer price inflation based on the tariffs implemented thus far, but we think this is an upper bound. Aside from explicit absorption mechanisms, the staggered implementation of tariffs and the varied timing of firms' responses means the effects of tariffs are likely to ripple through pricing over the next year or two rather than come all at once. Ultimately, we see core PCE inflation remaining near 2.8% this year—0.4 percentage points above our pre-tariff baseline—and subsiding only gradually through 2026 to remain above the Fed's target.

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