Tariffs, inflation and the Fed: How much luck does Powell have left?

Author: Chen Daotian

Since inflation began to significantly exceed the 2% target in March 2021, more than four years have passed, and the Fed has not yet brought inflation back to 2%. Now, Trump's tariff war will bring new price pressures, and the tax cut plan may bring additional economic stimulus. High inflation is likely to enter its fifth year. By comparison, the famous stagflation of the 1970s was "only" a decade. The Fed's persistent pursuit of the 2% inflation target has been long and arduous, reminiscent of García Márquez's "Love in the Time of Cholera".

Tariffs and Prices: How High Have They Got?

After the two tariff "pauses" on April 9 and May 12, the negotiations between the United States and its major trading partners, the European Union, China, and Japan, have not yet reached a conclusion. However, for the new tariffs that have already taken effect, there is now nearly two months of relatively complete data, which can roughly estimate the impact of tariffs on prices.

According to data from the American think tank "Bipartisan Policy Center", as of March 22, 2025, the total amount of tariffs collected by the U.S. Customs that year was $26.5 billion, and by May 22, 2025, the above figure changed to $67.3 billion; the figures for the same period in 2024 were $17.7 billion and $33 billion, respectively. The tariffs collected from March 22 to May 22, 2025 were $40.8 billion, $26 billion higher than the same period in 2024. The total amount of imported goods in the United States in these two months is about 640 billion US dollars. If the tariff burden is borne by American buyers and added to the final sales price, the price increase of imported goods should be about 4% (the new tariffs were implemented in April for a longer period of time, with a higher tax rate, and the price increase should account for a larger proportion, about 3%). In the total consumer consumption in the United States, imported consumer goods are about 1.7 trillion, accounting for 8.5%. In this case, the tariffs should additionally push up the CPI in April by about 0.3% month-on-month. Considering the original trend level, the CPI in April should be 0.5% month-on-month.

However, the CPI data released in April is far from this. The year-on-year growth rate of CPI in April was 2.3% and the month-on-month growth rate was 0.2%, both of which are at a low level in recent months. Some products with a high proportion of imports, such as clothing and toys, have zero month-on-month price changes, communication and electronic products are almost flat month-on-month, and medical supplies have increased by 0.4% month-on-month. There are several explanations for the above contradiction. One is that there is still inventory accumulation in imports, so prices will not rise for the time being, but they will rise later; another possibility is that foreign exporters bear most of the tariff burden, so domestic retail prices in the United States do not need to rise too much. These explanations need time to verify, but no matter which case, we can analyze a medium- and long-term economic "steady state" after the imposition of tariffs. Tariffs and "double reduction": a long-term analysis In a long-term open economy, if the fiscal deficit is reduced, this will increase overall savings. The extra savings of a country can be used for domestic investment or for foreign investment. The way to increase foreign investment is to export more, "earn more money from foreigners", and hold more foreign currency assets, which is reflected in trade as a reduction in trade deficit (or an expansion of trade surplus). While net exports increase, the fiscal deficit needs to decrease to keep output stable. This "double reduction" is what the United States urgently needs at present.

There are several different ways to reduce the trade deficit, such as through the devaluation of the US dollar or by imposing import tariffs. The devaluation of the US dollar reduces the trade deficit by making US goods cheaper (relative to foreign goods) and promoting foreign demand. Tariffs are just the opposite. They reduce US exports (because tariffs will lead to an appreciation of the US dollar), but also reduce US imports (imported goods become more expensive after taxation), and the trade surplus is expanded due to the greater decline in imports. In other words, the United States, as a country with a trade deficit, has become more closed through tariff barriers, and the US purchasing power has shifted more to its domestic products, which will lead to an increase in US domestic demand, thereby reducing the trade deficit (a completely closed economy would have a zero trade deficit).

I have analyzed in previous articles of this magazine that part of the tariff is borne by domestic residents, which is equivalent to a mandatory price increase to subsidize local products (it is necessary to remember that price increases can stimulate local production); part of it is borne by overseas exporters, who are forced to lower their export prices (the same exports earn less dollars), which is equivalent to transfer payments to the US government. Assume that the US trade deficit and fiscal deficit are both $900 billion before the tariff is imposed; assume that tariff revenue increases by $400 billion after the tariff is imposed, half of which is borne by the United States and the other half is borne by foreign exporters who reduce prices (for simplicity, changes in the US dollar exchange rate are not considered here); assume that the tariff leads to a reduction of the trade deficit by $200 billion.

In order to keep total demand unchanged, the decline of 200 billion trade deficit (expansionary) needs to match the decline of 200 billion fiscal deficit (contractionary). Among the tariffs collected, the 200 billion borne by the country is for contraction of total demand, which just matches the decline of trade deficit. Therefore, this part of tariff revenue does not need to be spent (thus achieving the effect of contraction of demand) and can be used to redeem the existing debt. In addition, the 200 billion tariffs borne by foreign countries (equivalent to international transfer payments) will not have a contractionary effect on US total demand, so they should all be used to reduce the existing debt. In this example, the trade deficit has declined, but the fiscal deficit can decline more, while the macroeconomy remains in a state of full employment. The fiscal deficit may decline more than the trade deficit. The significance of this conclusion cannot be ignored. According to the author's reading, this analysis is not considered by the mainstream view of Wall Street.

The long-term outlook looks good, but the specific path from the current "short-term" to the above-mentioned "long-term" requires more analysis.

Short-term "unconventional" stagflation

In the early stage of tariff implementation, the increase in the price of imported goods will lead to a decrease in the total supply of the United States, which means that the hedging relationship between inflation and unemployment has worsened. With the same unemployment rate, the inflation rate will be higher. A more academic term is the upward shift of the Phillips curve. Generally speaking, the movement of the Phillips curve is caused by inflation expectations. Imagine that people have a rough consensus on the future inflation rate, and then set product prices and wages based on it. However, the supply change caused by tariffs is completely different. It is caused by actual price increases, and this price increase is due to tariffs, just like forcing price increases by administrative orders. This small difference brings about a major difference in the conclusion.

The increase in inflation expectations leads to a contraction in supply, but does not affect aggregate demand. The supply contraction caused by tariffs will automatically tighten monetary conditions due to the actual increase in prices, which will lead to an increase in real interest rates. High interest rates will suppress aggregate demand in the short term (in addition, uncertainty will also affect investment), which increases the probability of recession. As mentioned earlier, tariffs "intercept" demand in the country, which promotes domestic demand. However, if the inhibitory effect of rising prices in the short term is greater, the market will worry about economic recession. This worry can explain the market decline in February-April to a considerable extent.

Unlike loose monetary policy, the price increase caused by tariffs is passive. It is the actual taxation that causes companies to passively increase prices. The price increase will end after the price transmission is fully completed. It is hard to imagine that the market will form higher inflation expectations during a period of weak demand (although prices are rising). Therefore, tariff stagflation is a new phenomenon. Unlike the "conventional" stagflation that people are familiar with in history, it is most likely temporary.

The peak of "unconventional" stagflation and interest rate cuts

When the price increase process caused by tariffs is completed, monetary policy is also in the most tight state, because the price level is the highest at this time, and the Federal Reserve has kept interest rates stable in order to stabilize inflation expectations. This is probably the "darkest moment" of the economy. However, the most serious price increase is also when the tariff impact is about to fade, and the opportunity for interest rate cuts will come with it. The interest rate cut will stimulate total demand, and the international capital outflow brought about by the downward interest rate will also be beneficial to exports. If fiscal policy is tightened at this time, it will be the beginning of the "double reduction" of the economy, thus moving towards the aforementioned long-term goal.

The Fed's economic outlook in March expected inflation to return to 2% by 2027, but when this forecast was made, the "reciprocal tariffs" and tax cuts had not yet been introduced. In a speech in Chicago in April, Powell expressed serious concerns about tariffs, believing that both inflation and the labor market were under pressure, which triggered a stock market crash that day. This caused extreme dissatisfaction from Trump, who demanded that the Fed cut interest rates and claimed that he had the right to replace Powell. At the press conference after the Fed's interest rate meeting in May, Powell once again emphasized the dual risks of rising inflation and a weak labor market. The high degree of uncertainty has led the Fed to adopt a "wait and see" strategy.

Compared with the "dilemma" attitude of most Fed directors, Waller expressed a more distinct view in a recent interview. He believes that the Fed should bravely admit that the inflation caused by tariffs is temporary, and once there are signs of weakening in the labor market, interest rates should be decisively cut. This is close to the author's previous position of "unconventional stagflation". In the May policy statement, the Fed still believes that the labor market is strong, but some indicators have hinted at hidden worries. The recent ratio of job vacancies to unemployed people in March was close to 1, which is lower than the generally believed normal level before the epidemic (1.2). Another factor should not be ignored. The demand for services and goods is mutually substitutable. If the price of goods increases, then the demand may shift more to services, so the overall price increase will not be so large. In addition, the price increase of goods will lead to a decline in real income, which will also slow down the increase in service prices.

The current policy interest rate is contractionary, and there should not be too much doubt about this. Inflation will eventually slow down, but the timing is full of uncertainty. The short-term path analyzed in this article includes two stages: "unconventional stagflation" and "interest rate cuts", but the progress of trade negotiations and the final scale of fiscal tax cuts will bring more variables. The 2% inflation target is very beautiful, but it is not easy for the Federal Reserve to pursue it, just like "Love in the Time of Cholera" written by Marquez.

Reaction of US stocks and US bonds

From mid-February to early April this year, a few days after Trump announced the reciprocal tariffs, the 10-year interest rate and US stocks had good synchronization. The market was worried about the economic recession caused by tariffs, so when the US bond interest rate fell, the stock market also tended to fall.

The situation changed suddenly between April 7 and April 9. The 10-year Treasury bond rate rose by 33 basis points in three days. There were signs of panic in the financial market. Treasury bonds were no longer considered safe, and the market demand for cash increased sharply. This extremely abnormal phenomenon only occurs during extreme panic, such as during March 9-18, 2020, when the extreme panic about the COVID-19 pandemic caused the 10-year Treasury bond rate to rise sharply from 0.54% to 1.18%. The three-day stock and bond plunge crushed Trump's confidence in the tariff plan. On Wednesday afternoon, April 9, the White House hastily announced a tariff suspension.

On April 11, the Treasury bond rate rose to a stage high of 4.48%, then quickly fell to 4.17%, and then rose again to 4.58% on May 21, which was roughly a V-shaped. This extreme fluctuation reflects the high uncertainty of the macro economy. The different signals of "stagnation" and "inflation" have a sharp impact on the bond market in opposite directions. The stock market is much better after the tariffs are suspended. The most drastic policy risks have passed. Whether the subsequent signals are stagnation or inflation, as long as they are relatively mild, they are all good. Looking forward to the future of the U.S. stock market, with the transmission of prices, the "unconventional stagflation period" gradually begins, and the U.S. stock market may begin to bear some pressure after a sharp rebound. When this stage is over and the Federal Reserve begins to have the confidence to cut interest rates, the U.S. stock market is expected to enter a more favorable period. At the same time, recession risks need to be carefully evaluated.

How much luck does Powell have left?

Fifty years later, the lovers in "Love in the Time of Cholera" unexpectedly reunited (Chinese novelists are much more merciful, usually ten years, at most twenty years). For the Federal Reserve, it may not be possible to fully achieve the goal of reducing inflation to 2% until 2027, which is six years from the beginning of 2021. Six years is too long for a policy cycle or a term of office of a Federal Reserve chairman, which is roughly equivalent to fifty years for a human. The difference is that the protagonist in "Cholera" has "won", while Powell is still exploring hard.

Powell will step down in May 2026. He is lucky. His experience is as magnificent as that of Greenspan and Bernanke, and richer than that of his two legendary predecessors. In just 7 years, Powell has experienced the economic stagnation under the new crown epidemic, a QE larger than that of 2009-2015, a 40-year high inflation, an epic and almost perfect soft landing, and two fierce trade wars. He is already a celebrity. At the Chicago Fed’s employee meeting in April (everyone from economists to cleaners were invited to attend), people asked about his daily work habits and hobbies. If the US economy can avoid recession again when he leaves office next year, Powell’s luck will be really good, and he will have reason to read "Love in the Time of Cholera."