Tariffs Mask Falling Inflation: Business Leaders' Guide To Fed Policy

New research from Harvard Business School's Pricing Lab suggests that tariffs are significantly contributing to current inflation, indicating that without their effect, the U.S. inflation rate (PCE equivalent) would already be near the Federal Reserve's 2% target. This presents a critical policy challenge for the Fed: whether to 'see through' tariff-induced price increases, which monetary policy cannot directly address without harming employment, or to tighten if inflation expectations become unanchored due to the gradual pass-through of tariff costs. The article anticipates the Fed will likely adopt a 'see-through' approach, leading to some interest rate easing over the next 12 months, though potentially less aggressive than dovish members might desire, reflecting the nuanced impact of tariffs on inflation and expectations.

Analysis

New research from Harvard Business School's Pricing Lab indicates that tariffs significantly inflate U.S. consumer prices. The study suggests that without tariffs, the August 2025 CPI of 2.9% would have been approximately 2.2%. Adjusting for the PCE's typical 0.4 percentage point lower average than CPI, this implies underlying inflation is already near the Federal Reserve's 2% target, translating to roughly 2.3% CPI without tariff effects.

This presents a critical monetary policy challenge, as tariff-induced inflation cannot be addressed by interest rate hikes without risking employment and production. The Federal Reserve has previously analyzed and referenced a "seeing through" approach, where policy focuses on underlying inflation, effectively disregarding tariff impacts. This strategy hinges on inflation expectations remaining well-anchored.

However, the gradual pass-through of tariff costs over time could unanchor inflation expectations, potentially forcing the Fed to tighten policy despite the economic costs. The article anticipates the Fed will likely adopt a cautious "see-through" stance, leading to some interest rate easing over the next 12 months. This easing is expected to be less aggressive than some dovish members might prefer, reflecting the complexity and uncertainty surrounding tariff impacts on inflation.

Key Decisions for Investors

• Investors should closely monitor Federal Reserve communications for explicit references to "seeing through" tariff effects or shifts in their inflation expectation management strategy.
• Anticipate a measured, rather than aggressive, pace of interest rate cuts over the next 12 months, as the Fed balances underlying inflation targets with potential risks from unanchored expectations.
• Evaluate potential impacts on sectors heavily reliant on imported goods or those sensitive to consumer discretionary spending, given the nuanced inflation outlook and potential for gradual tariff pass-through.