Tariffs Are Coming: How Trade Dynamics Will Shape Aggregate Demand and Inflation

Yves here. This article contends that tariffs may not be inflationary, but that does not mean that consumers will not be harmed. Tariffs will make some, perhaps many, goods more expensive. But buying them (or driving up prices of competing non-tariffed products) will leave consumers with less to spend on other things. That reduction in effective demand will mitigate the inflationary impact of tariffs. But consumers will be worse off by virtue of being able to buy less stuff.

By Diego Comin, Professor of Economics Dartmouth College and Robert Johnson. Originally published at VoxEU

Donald Trump has promised a raft of new tariffs, prompting concerns about a concomitant increase in inflation. This column argues that tariffs do not necessarily raise inflation, which is a macroeconomic phenomenon. Assumptions about how tariffs and trade evolve – whether tariff changes are temporary or permanent, and whether trade reacts immediately to those changes or adjusts sluggishly over time – shape how inflation responds. A phased decrease in trade that lowers inflation offers only false comfort, as deglobalisation reduces inflation by making us poorer over time, eroding the gains from trade.

Tariff threats are flying left and right. Since his re-election, Donald Trump has threatened to impose a 10% across-the-board tariff, a 60% tariff on China, a 25% tariff on Mexico and Canada, and a 100% tariff on emerging markets that abandon the US dollar as a reserve currency. Not to mention the punitive tariffs on Denmark if they don’t hand over Greenland! Specifics aside, the arrow points up for US protectionism, foreign retaliation is likely to follow, and the outlook for international trade looks dim.

Against this backdrop, many observers have expressed alarm that the proposed tariffs will raise inflation. Most on point, in the December Federal Open Market Committee (FOMC) minutes, the Federal Reserve cited “potential changes in trade policy” as a reason why inflation might remain elevated into 2025.

The logic underlying the ‘tariffs cause inflation’ argument seems obvious. Tariffs on imported consumer goods feed directly into the consumer price index. For domestic firms, tariffs on imported inputs increase production costs, which are passed onto consumers. Further, by shielding domestic producers from import competition, tariffs allow them to raise their markups, again increasing the cost of domestically produced goods for consumers. Moreover, there is good evidence that growth in US consumer prices has been restrained in sectors where imports from China have increased (Bai and Stumpner 2019, Jaravel and Sager 2024). And previous Trump tariffs appear to have been largely passed through to US consumers (Amiti et al. 2019).

Despite these channels, the conclusion that tariffs raise inflation does not necessarily follow. Why? Because inflation is a macroeconomic phenomenon. Reasoning about inflation based on the impact that tariffs have on prices in partial equilibrium or on relative prices (for imports versus domestic goods, or for sectors exposed to tariffs versus those that are not) can be misleading.

In the workhorse New Keynesian (NK) paradigm, inflation depends on the interaction between aggregate demand and supply forces. Through the lens of this framework, all the effects of tariffs cited above work through the supply side of the model. Embedded in the Phillips Curve, they raise inflation by increasing costs (conditional on wages) and/or markups set by domestic producers. But the demand side matters too. In our research (Comin and Johnson 2022), we argue that (typically overlooked) impacts of trade on aggregate demand are crucial for evaluating how changes in trade impact inflation.

Consider a simple thought experiment. Suppose that an initially closed economy announces it will open up to international trade (e.g. by lowering tariffs). Reflecting real-world experience, let us also assume that the transition from the closed to open equilibrium takes time; tariff reductions may be phased in over time, or trade patterns may adjust slowly to tariff reductions, even if tariffs are cut immediately. In this scenario, one expects imports (as a share of domestic expenditure) to rise over time. Assuming there are gains from trade, this implies that we expect to be richer in the (open) future than the (closed) present. That is, trade liberalisation is associated with good news about the future, and thus the anticipation of higher future consumption, which arrives before the increased trade itself is fully realised.

In standard NK models, good news about future consumption possibilities (whether due to imports or to productivity more generally) puts upward pressure on inflation. Specifically, knowing they will have higher future consumption, agents attempt to pull consumption forward in time, raising the (real) natural rate of interest. This manifests as a demand shock, increasing the output gap given inflation, all else being equal. As long as monetary policy does not fully offset this increase in aggregate demand, inflation then rises in response. The punchline is that trade liberalisation – which triggers an anticipated increase in imports over time – places upward pressure on inflation.

In our work, we first illustrate how this intuition appears in a benchmark NK model with a single sector, trade in consumption goods and inputs, complete financial markets, and dollar currency pricing. We then show that the intuition extends to more sophisticated models, including medium scale models with capital accumulation and habits, models that relax international risk sharing, models that allow trade to have pro-competitive effects (where import competition reduces markups for domestically produced goods), and models that allow for multiple sectors to provide more quantitative realism. Further, we demonstrate that the demand-side effects are strongest when increases in offshoring – the use of foreign inputs in production – account for rising trade, as they have in recent decades for the US.

What is surprising about these results is that they run counter to most commentary on tariffs and inflation by academics, journalists, and policymakers. Our conjecture is that this standard intuition comes from thinking about the impact of temporary trade cost shocks, rather than the anticipated, long-lasting changes in trade that we consider. Indeed, we find that temporary reductions in import penetration – as would be induced by temporary increases in tariffs – do raise inflation on impact. As such, our framework can accommodate empirical evidence that temporary increases in trade costs drive inflation higher (Cuba-Borda et al. 2024). Further, it is generally consistent with the analysis of optimal monetary policy by Bergin and Corsetti (2024), which again focuses on temporary tariff shocks.

This serves to re-emphasise a key point: assumptions about how tariffs and trade evolve over time – whether tariff changes are temporary or permanent, and whether trade reacts immediately to those changes or adjusts sluggishly over time – shape how inflation responds. More concretely, if the incoming Trump administration adopts restrictive policies that lead to a phased reduction in trade over time, this augurs lower inflation as the deglobalisation process plays out. In contrast, if policies enacted by the Trump administration only temporarily restrict trade (e.g. supposing we expect policy to be reversed by future presidents), then those policies may push inflation higher. In the end, inflation is shaped by the trade dynamics induced by policy.

As a final note of caution, the prediction that a phased decrease in trade might lower inflation offers false comfort. Deglobalisation would reduce inflation because it makes us poorer over time, eroding the gains from trade. Policies that reduce welfare are self-destructive on their face, even if they entail lower inflation.

See original post for references