With a new administration set to take control in 2025, investors are thinking about tariff policy and grappling with potential outcomes.
The greatest fear is that new broad-based tariffs will increase inflation, lead to rising interest rates, and potentially trigger a recession. If the three aforementioned were to simultaneously happen, then we’d likely repeat 2022 in capital markets. As you remember, US stocks and bonds both had double digit negative returns for the year. This was a situation that had not occurred since the 1960s.
With deceptive information being spread in media outlets, I think it is worth reviewing how/if tariffs really cause inflation. This is not a political commentary for or against tariffs. There are arguments separate from economics that could make tariffs sound/unsound policy. One might argue the merits of tariffs for geopolitical reasons, national security reasons, or as a negotiation tool. We will stick to economics.
If the intent is for economies to grow and produce at their most efficient, there would be no tariffs. Goods and services would be produced where they are most efficiently produced. Tariffs distort the natural market and create outcomes that otherwise may not have occurred and do so at different prices.
If the NFL decided it wanted the Cowboys to be more competitive with the Packers, when the two teams played, it might not allow the Packer players to not wear cleats, and gloves. Maybe the Cowboys would automatically receive the first and second half kickoffs. In this scenario, the outcome might not be different, but the final score would certainly be different, and the product (Packer performance) would be inferior for the price.
Why would any country or anyone be in favor of tariffs if they create lower quality and/or higher priced end outcomes? The quick answer is that if you are a Cowboys fan, you might care more about the Cowboys than you do about having the best, most efficient, and meritocratic outcome. The argument is that the cost of tariffs is spread across all consumers, but the benefits tend to favor lower income, lower skilled, production workers. Traditionally, democrats have been more pro-tariff because it was seen as pro-worker, republicans have typically been more anti-tariffs seeing it as anti-free market.
Enough about economics, what do tariffs mean for inflation (and markets)? Tariffs can create a one-time short-term price bump for goods/services. However, static tariff policy does not continually increase inflation, and over the long-run tariffs have no effect on inflation.
Let’s say we have Jack, and Jack has one dollar to spend. He only wants to buy two items. He buys $0.50 worth of butter, and that gets him one stick of butter. He buys $0.50 worth of ammo, and that gets him two boxes of ammo.
Then tariffs happen, but Jack still only has $1.00. Now he buys $0.75 worth of butter, and $0.25 worth of ammo. Jack still gets his one stick of butter, but now at $0.75. Jack buys $0.25 worth of ammo, but instead of getting two boxes, he only gets 1/2 a box. He spends the same total but gets less. This is the short-term bump in action. Before he got two boxes of ammo and one stick of butter for $1.00 but now, he needs $1.75 for the same goods. Inflation, right?
Not so fast my friends. Jack’s demand for butter was $0.50, and same for ammo to start with. However, his demand for ammo reduced to $0.25 when the price of butter rose. Over the longer run we know that when demand falls, prices fall too. In our example, over the long run the price of ammo would come down, because there was no increase to the money supply and the demand for ammo decreased.
The Bottom Line: Unless there is an increase in the money supply or rate of money supply expansion, tariffs alone, are not inflationary. Therefore, if interest rates rise, it is not a result of tariff policy. Tariffs can and presumably would reshape the economic playing field. Depending on what team or outcome you are rooting for, that reshaping could be positive or negative.
Wyatt Swartz
Written 12/23/2024