The Effect Of Trade Tariffs Upon Inflation Will Be More Than The Market Is Currently Estimating

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by: Tim Worstall
Summary

A current market estimate is that the US tariffs on China trade will add 0.4% of US consumer price inflation.

The Federal Reserve won't change interest rates to deal with a transitory issue like this.

But I fear that this is an incorrect estimate - it's not including the prices rises domestic producers will be able to make.

An important effect of trade tariffs is, well, who pays them? There are a few alternatives available to us from theory. One is, the idea that Donald Trump, Robert Lighthizer, Peter Navarro put forward, the idea that it is the producers in those foreign countries. They either lower their profit margins in order to keep prices inside the tariff barriers stable or they lose the sales altogether.

There's very little empirical proof that this is what happens with everything even though it's obviously possible. In markets and with items with very high elasticity of demand with respect to price this would be true. If we imposed a tariff upon oil from just the one country - so, on a fungible commodity from only the one source - then this would be true.

Few items actually work like that, certainly few manufactured ones do.

So, we move to the next set of people who might pay, the importers. Again this will depend upon elasticity of demand in the domestic market. The higher this is - thus the more sales they'll lose from higher prices - the more the importers or retailers will compress profit margins to continue selling.

Then there's the third option, the consumers in the country behind the tariff barriers. Prices go up as a result of the tariffs, consumers pay those higher prices, it's consumers paying the tariffs. And clearly and obviously this will mean that tariffs are contributing to inflation inside that "protected" economy.

Moody's Analytics has an estimate of what that inflation might be from the China tariffs:

In all, those goods subject to tariffs account for about 5% in the core CPI, and China accounts for varying amounts of imports, suggesting the impact on these prices will vary. Still, this bottom-up approach would suggest that if all of the tariffs are passed through to the consumer, it would boost year-over-year growth in the core CPI by 0.4 of a percentage point. Odds are that the impact will be smaller, as some U.S. businesses will eat the cost or risk losing sales. Therefore, we expect the boost to inflation will be closer to 0.2 of a percentage point. However, the Office of the U.S. Trade Representative released its plan for imposing a 25% tariff on all remaining imports from China, and those are more heavily concentrated in consumer goods and would be noticeably more inflationary. Because import prices exclude duties, the inflationary impact of tariffs will be more visible in consumer prices.

There's nothing wrong with that analysis as far as it goes. But I'm not certain that it goes far enough. Because what's the other thing that happens when we impose tariffs. In fact, what's one reason we do impose tariffs?

So that domestic producers can raise their prices. Think what happens when we have anti-dumping tariffs. Our claim is that the foreigners are selling too cheap. This means that our domestic producers cannot compete. We have the tariffs so that - expressly because we want this to happen - domestic producers can raise their prices. Do note that economic effects do not depend on why we're doing something, they depend upon what we've done. So, impose tariffs and that means that domestic producers can raise prices.

Thus the inflationary effect of tariffs isn't just the price change from imports, but that plus also the domestic price rises they enable.

The importance to us as investors is that we shouldn't allow ourselves to get spooked by changes in the CPI caused by this. For, as Moody's points out, such tariff caused changes in import prices - and domestic - are once only events. They are, in the jargon, transitory. They happen, they're in the CPI calculation for 12 months and then, as those once only happenings, they drop out again.

Monetary policy isn't effective concerning once only events. It's ongoing inflation that it does work against.

So, the tariffs will raise US CPI inflation. But we shouldn't expect the Federal Reserve to raise interest rates in response. For we know and the Fed knows that rising interest rates doesn't deal with this tariff caused inflation anyway.

So, something for us to be aware of. There's a rise in inflation baked into the system but this particular rise isn't going to lead to a change in Fed policy and thus interest rates. We shouldn't thus position ourselves for Fed action as a result of the tariffs and their inflation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.