inflation

Do Tariffs Decrease Prices?

Zachary Bartsch2 Comments

Much of what economics has to say about tariffs comes from microeconomic theory. But it’s mostly sectoral in nature. Trade theory has some insights. But the effects on the whole of an economy are either small, specific to undiversified economies, or make representative agent assumptions that avoid much detail. Given that the economics profession has repeatedly said that the Trump tariffs would contribute to inflation, it seems like we should look at the historical evidence.

Lay of the Land

Economists say things like ‘competition drives prices closer to marginal cost’. Whether the competitor lives abroad is irrelevant. More foreign competition means lower prices at home. But that’s a partial equilibrium story. It’s true for a particular type of good or sector. What happens to prices in the larger economy in seemingly unrelated industries? The vanilla thinking that it depends on various elasticities.

I think that the typical economist has a fuzzy idea that the general price level will be higher relative to personal incomes in some sort of real-wages and economic growth mental model. I don’t think that they’re wrong. But that model is a long-run model. As we’ve discovered, people want to know about inflation this month and this year, not the impact on real wages over a five-year period.

Part of the answer is technical. If domestic import prices go up, then we’ll sensibly see lower quantities purchased. The magnitude depends on the availability of substitutes. But what should happen to total import spending? Rarely do we talk about the expenditure elasticity of prices. Rarely do we get a simple ‘price shock’ in a subsector. It’s unclear that total spending on imports, such as on coffee, would rise or fall – not to mention the explicit tax increase. It’s possible that consumers spend more on imports due to higher prices, or less due to newly attractive substitutes. The reason that spending matters is that it drives prices in other parts of the economy.

For example, I argued previously that tariffs reduce dollars sent abroad (regardless of domestic consumer spending inclusive of tariffs) and that fewer dollars will return as asset purchases. I further argued that uncertainty makes our assets less attractive. That puts downward pressure on our asset prices. However, assets don’t show up in the CPI.

According to the above discussion, it’s unclear whether tariffs have a supply or demand impact on the economy. The microeconomics says that it’s a supply-side shock. But the domestic spending implications are a big question mark.

What is a Tariff Shock?

That’s the title of a recent working paper from the Federal Reserve Bank of San Francisco. It’s a fun paper and I won’t review the entirety. They start by summarizing historical documents and interpreting the motivation of tariffs going back to 1870. They argue that tariffs are generally not endogenous to good or bad moments in a business cycle and they’re usually perceived as permanent. The authors create an index  to measure tariff rates.

Here’s the fun part. They run an annual VAR of unemployment, inflation, and their measure of tariffs. Unemployment in negatively correlated with output and reflects the real side of the economy. Along with inflation, we have the axes of the Aggregate Supply & Aggregate Demand model. Tariffs provide the shock – but to supply or demand?.  Below are the IRF results:

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Macroeconomic Policy In a Nutshell

James BaileyLeave a comment

What I’m telling my Intro Macro students on the last day of class, since we weren’t able to get through every chapter in the textbook:

A few of you might end up working in economic policy, or in highly macro-sensitive businesses like finance. For you, I recommend taking followup classes like Intermediate Macroeconomics or Money and Banking so you can understand the details. For everyone else, here are the very basics:

  1. In the long run, economic growth is what matters most. The difference between 2% and 3% real GDP growth per capita sounds small in a given year, but over your lifetime it is the difference between your country becoming 5 times better off vs 10 times better off.
  2. How to increase long-run economic growth? This is complicated and mostly not driven by traditional macroeconomic policy, but rather by having good culture, institutions, microeconomic policy, and luck.
  3. In the shorter run, you want to avoid recessions and bursts of inflation.
  4. High inflation means too many dollars chasing too few goods. To fix it, the federal government and the central bank need to stop printing so much money (the details can get very complicated here, but if we’re talking moderately high inflation like 5% the solution is probably the central bank raising interest rates, and if we’re talking very high inflation like 50% the solution is probably a big cut to government spending).
  5. If there is a recession (which will look to you like a big sudden increase in layoffs and bankruptcies), the solution is probably to reverse everything in the previous point. The government should make money ‘easier’ via the central bank lowering interest rates while the federal government spends more and taxes less.
  6. If you don’t take more economics classes, you will likely hear about macro issues mainly through the news media and social media. You should be aware of their two main biases: negativity bias and political bias.
    • Negativity Bias: If It Bleeds, It Leads on the news. Partly this is because bad news tends to happen suddenly while good news happens slowly, so it doesn’t seem like news; partly it just seems to be what people want from the news and from social media.
    • Political Bias: People tend to seek out news and social media sources that match their current preferences. These sources can be misleading in consistent ways for ideological reasons, or in varying ways based on whether the political party they like is currently in power.
  7. There are different ways to measure each key macroeconomic variable. Think through them now and make a principled decision about which ones you think are the best measures, and track those. Otherwise, your media ecosystem will cherry-pick for you whichever measures currently make the economy look either the best or the worst, depending on what their biases or incentives dictate.
  8. There are good ways to keep learning about economics outside of formal courses and textbooks, I list a few here.

Bad Claims About Food Stamps (SNAP)

Jeremy Horpedahl10 Comments

One of the likely effects of the federal government shutdown is that recipients of SNAP benefits (what used to be officially called “food stamps,” a term still used by the general public, especially those that dislike the program) may lose their benefits next month. This would obviously be a hardship for those that depend on this program, but it has also led to bad claims being made about the program, from both supporters and opponents of the program.

Let’s start from the political right: Matt Walsh makes the claim that by subsidizing food consumption “obviously drives up the cost” of groceries.

As with all bad claims, there is a nugget of truth baked into them. If the government subsidizes anything, we would expect demand to increase, and thus unless supply is perfectly elastic, there will be some effect on prices. However, we need to think more carefully about the nature of the subsidy.

The way SNAP works is that beneficiaries receive an electronic voucher to spend at the grocery store, which is about $300 per month on average for a household. That $300 must be spent on groceries. However, if that household had already planned to spend $300 or more on groceries, it is unlikely they will spend all of the additional $300 on food. In the limit, it’s entirely possible they will spend no additional money on groceries, merely reducing their out-of-pocket spending on groceries by $300. They will then effectively have $300 more to spend on other goods. More likely is that they will spend some of the additional $300 on groceries, and some of it on other goods.

Many studies have tried to look at the extent to which SNAP benefits affect household spending, but these were mostly observational studies. There was no treatment and control group. But a 2009 paper titled “Consumption Responses to In-Kind Transfers: Evidence from the Introduction of the Food Stamp Program” has a better approach to studying the question. Since the original Food Stamp program was slowly rolled out across the country over more than a decade, you can compare counties that entered the program first to counties that entered it later. By doing so, Hilary Hoynes and Diane Schanzenbach find out some first interesting things about the causal effects of SNAP benefits.

For the claim by Walsh in his Tweet, the most relevant result from the paper is that food stamps impact household spending similarly to a cash transfer. Yes, the program increases household spending on groceries, but it also increases spending on other goods and services. And it does so almost identically to how cash transfers impact household spending. In other words, while pitching the program as assistance for buying groceries may make it more politically palatable, SNAP benefits are no different from a similarly-sized cash transfer for the average recipient. If they do cause any inflation, they do so in the same way as a cash transfer would, and thus there is no specific impact on food inflation.

A second bad claim about SNAP comes from the political left, in this case Minnesota Governor Tim Walz:

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The “Lost World” of 2% Inflation

Scott BuchananLeave a comment

Here is a chart of the Core Personal Consumer Index for inflation (Core PCE), which is the Fed’s favorite measure on inflation, from 1970 through early 2024:

This chart is from an article by the Richmond Fed, The Origins of the 2 Percent Inflation Target. That article has a long discussion of how and why the Fed decided to name an explicit inflation target of 2% in 2012. Although controlling inflation has been formally part of the Fed’s “dual mandate” since the Federal Reserve Reform Act of 1977, it had traditionally not set a single numerical target. After years of discussions within the Fed, it was decided that the benefits of a clear single target outweighed the potential downsides. 2% was though to be about the lowest you could run, while still giving the Fed some room to cut short term rates in a recession without running up against the dreaded zero lower bound. It was understood that 2% was a loose target, with some years a little over or under to be allowed to balance each other out.

That Richmond Fed article was published in early 2024. At that point, inflation was falling quickly and steadily from its post-Covid high, as consumers finished spending down their gigantic stimulus package windfalls.

Unsurprisingly, this article concludes that “Even during this period, long-run inflation expectations have remained anchored, rising no higher than 2.5 percent, according to the Cleveland Fed.”

That was about 18 months ago. The actual path of inflation since then has not be a descent to 2-2.5%. Between gigantic peacetime deficits by two administrations, and the results of tariffs, inflation seems to have leveled out at around 3%:

Source

The sub-2% inflation that was normal for twenty years (2000-2020) may now be a lost world.   This puts the Fed in an awkward spot. Even ignoring the irresponsible squawking from some quarters of the government, it will not be an easy decision to keep cutting rates (to address soft employment) if inflation stays this high. The Fed’s mantra this time around is that the current inflation is just a transient response to tariffs and so can be largely discounted. But I recall similar verbiage in 2021, as the Fed dismissed the ramping inflation back then as merely a transitory effect of pandemic supply chain restrictions. They were wrong then, and I suspect it would be wrong now to be too complacent. The 1970s-80’s showed that once the inflation genie gets out of the bottle, it can be very costly to subdue it. Whether 2.0 % is still the right target, however, may be open to debate.

Don’t Cut Rates

James Bailey2 Comments

The Federal Reserve will probably cut rates next week:

I can’t advise them on the complex politics of this, but based on the economics I think cutting would be a mistake. I see one good reason they want to cut: hiring is slow and apparently has been for a year. But that could be driven by falling labor supply rather than falling demand, and most other indicators suggest holding rates steady or even raising them.

Most importantly, inflation is currently well above their 2% target, 2.9% over the past year and a higher pace than that in August. Inflation expectations remain somewhat elevated. Real GDP growth was strong in Q2 and looks set to be strong in Q3 too, and NGDP growth is still well above trend.. The Conference Board’s measure of consumer confidence looks bad, but Michigan’s looks fine.

Financial conditions are loose, with stocks at all time highs and credit spreads low. Its only September and we’ve already seen more Initial Public Offerings than in any year since 2021 (when the last big bout of inflation kicked off):

Source: https://stockanalysis.com/ipos/statistics/

Crypto prices are back near all time highs and crypto is becoming more integrated into public stocks through bitcoin treasury companies and IPOs from Gemini and Figure.

The Taylor Rule provides a way of putting all this together into a concrete suggestion for interest rates. Some versions of the rule say rates are about on target, while others including my preferred Bernanke version suggest they should be closer to 6%. To me this is what the debate should be- do we keep rates steady or raise them? I see good arguments each way, but the case for a cut seems very weak.

I look forward to finding out in a year or two whether I or the FOMC is the crazy one here.

* The Usual Disclaimer, hopefully extra obvious in this case: These views are mine and I’m not speaking for any part of the Federal Reserve System.

Inflation Is Stuck

Jeremy HorpedahlLeave a comment

Here’s a somewhat niche measure of inflation: 6-month CPI excluding food, shelter, and energy. It might seem like a weird measure, as it excludes over half of the CPI. But there is a logic to at least considering it along with other measures.

Food and energy are both volatile, so they can give us a lot of noise. That’s why “core CPI” and other core measures are followed closely by the Fed and inflation watchers. But excluding shelter might also make sense, because increasing housing prices are largely due to supply constraints, and will move independently of monetary policy to some extent. Six-month inflation is also useful for a more timely measure than 12 months, the headline number.

As you can see in the chart above, this niche measure of inflation has been stuck for two and a half years. It has oscillated between about 0.5% and 1.5% since December 2022. And right now it’s almost exactly in the middle of that range. It has come down from 6 months ago, but higher than 1 year ago.

As you can see in the pre-2020 years, it generally oscillated between 0% and 1%. So 6-month inflation is stuck about 0.5% higher than we had become used to, which translates into roughly 1% higher annually.

In the grand scheme of things, 1% higher inflation isn’t the end of the world. But we do seem to be stuck at a slightly elevated rate of inflation relative to the decade before 2020.

The Middle/Working Class Has Not Been “Hollowed Out”

Jeremy Horpedahl6 Comments

Claims that the middle class or working class has been “hollowed out” in the US have been made for years, or decades really. The latest claim is an essay in the Free Press by Joe Nocera. But these claims are usually lacking in data, while strong in anecdotes. Let’s look at the data.

One data point we might use is median weekly earnings for full-time workers with a high school diploma, but no college degree. That sounds like a reasonable definition of “working class.” Here’s what that data looks like adjusted for inflation with the PCE Price Index:

Notice that the latest data point is for 2024, which is the highest they have ever been in this data series, and likely higher than any point in the past. While many point to about the year 2000 as when troubles for the working class started (this is when manufacturing employment really fell off a cliff, and China joined the WTO in 2001), inflation-adjusted earnings have risen 11% for this group of workers since then. You might say that’s not a lot of growth — and you would be correct! But this group is better off economically than in the year 2000, which is a point that gets lost in so many discussions about this issue.

But that’s just a national number. Might some states that were especially hit by manufacturing job losses be worse off? Nocera mentions North Carolina and the Midwest. To answer this, we can use BLS OEWS data, which has not only median wages by state, but also the 10th percentile wage — the lowest of the working class. Here’s what median real wage growth (again inflation-adjusted with the PCEPI) since 2001 (the earliest year in this series with comparable data):

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Forecasting the Fed: Description Vs Prescription

Zachary BartschLeave a comment

After raising rates in 2022 to belatedly combat inflation, the FOMC was feeling successful in 2024. They were holding the line and remaining steadfast while many people were getting all in a tizzy about pushing us into a recession. People had been predicting a recession since 2022, and the Fed kept the federal funds rate steady at 5.33% for an entire year. Repeatedly, in the first half of 2024, betting markets were upset that the Fed wasn’t budging. I had friends saying that the time to cut was in 2023 once they saw that Silicon Valley Bank failed. I remained sanguine that rates should not be cut.

I thought that rates should have been higher still given that the labor market was strong. But, I also didn’t think that was going to happen. My forecasts were that the Fed would continue to keep rates unchanged. At 5.33%, inflation would slowly fall and there was plenty of wiggle room for unemployment.

Then, we had a few months of lower inflation. It even went slightly negative in June 2024. Some people were starting to talk about overshooting and the impending recession. I documented my position in August of 2024. Two weeks later, Jerome Powell gave a victory lap of a speech. He said that “The time has come for policy to adjust”.  Instead of discerning whether the FOMC would cut rates, the betting markets switched to specifying whether the cut would be 0.25% or 0.5%. The Fed chose the latter, followed by two more cuts by the end of the year.

https://fred.stlouisfed.org/graph/?g=1DIsX

I was wrong about the Fed’s policy response function. But why? Was the FOMC worried about the downward employment revisions? That was big news. Did they think that they had inflation whipped? I’m not sure. There was a lot of buzz about having stuck the soft landing. In late 2024, I leaned toward the theory that the Fed was concerned about employment. Like, they thought that we had been doing better until then.

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Forecasting 2025

James BaileyLeave a comment

WSJ’s survey of economists reports that inflation expectations for 2025 were around 2% before the election, but are closer to 3% now. Their economists expect GDP growth slowing to 2%, unemployment ticking up slightly but staying in the low 4% range, with no recession. The basic message that 2025 will be a typical year for the US macroeconomy, but with inflation being slightly elevated, perhaps due to tariffs.

Kalshi has a lot of good markets up that give more detailed predictions for 2025:

For those who hope for DOGE to eliminate trillions in waste, or those who fear brutal austerity, the message from markets is that the huge deficits will continue, with the federal debt likely climbing to over $38 trillion by the end of the year. This is one reason markets see a 40% chance that the US credit rating gets downgraded this year.

While the US has only a 22% chance of a recession, China is currently at 48%, Britain at 80%, and Germany at 91%. The Fed probably cuts rates twice to around 4.0%.

Will wage growth keep pace with inflation? It’s a tossup. Corporate tax cuts are also a tossup. The top individual rate probably won’t fall below it’s current 37%.

If you want to make your own predictions for the year, but don’t want to risk money betting on Kalshi, there are several forecasting contests open that offer prizes with no risk:

ACX Forecasting Contest: $10,000 prize pool, 36 questions, must submit predictions by Jan 31st

Bridgewater Forecasting Contest: $25,000 prize pool, half of prizes are reserved for undergraduates. Register now to make predictions between Feb 3rd and March 31st. Doing well could get you a job interview at Bridgewater.

Is the Great Grocery Inflation Over?

Jeremy HorpedahlLeave a comment

The average price of a dozen eggs is back up over $4, about the same as it was 2 years ago during the last avian flu outbreak. Egg prices are up 65% in the past year. But does that mean the grocery inflation we experienced in 2021-22 is roaring back?

No really. Spending on eggs is around 0.1% of all consumer spending, and just about 2% of consumer spending on groceries. Symbolically, it may be important, since consumers pick up a dozen eggs on most shopping trips. But to know what’s going on with groceries overall, we have to look at the other 98% of grocery spending.

It’s been a wild 4 years for grocery prices in the US. In the first two years of the Biden administration, grocery prices soared over 19%. But in the second two years, they are up just 3% — pretty close to the decade average before the pandemic (even including a few years with grocery deflation!).

As any consumer will tell you, just because the rate of inflation has fallen doesn’t mean prices on average have fallen. Prices are almost universally higher than 4 years ago, but you can find plenty of grocery items that are cheaper (in nominal terms!) than 1 or 2 years ago: spaghetti, white bread, cookies, pork chops, chicken legs, milk, cheddar cheese, bananas, and strawberries, just to name a few (using BLS average price data).

There is no way to know the future trajectory of grocery prices, and we have certainly seen recent periods with large spikes in prices: in addition to 2021-22, the US had high grocery inflation in 2007-2009, 1988-1990, and almost all of the period from 1972-1982 (two-year grocery inflation was 37% in 1973-74!). Undoubtedly grocery prices will rise again. But the welcome long-run trend is that wages, on average, have increased much faster than grocery prices: