Why Tariffs Don’t Necessarily Mean Inflation

Tariffs are argued to cause a 'one-off shock' to prices rather than sustained inflation, a perspective supported by Fed Chair Powell. While goods prices have accelerated to 1.5% in August 2025, moderating services inflation has kept core inflation relatively stable around 3%, suggesting a relative price adjustment rather than broad inflation, contingent on anchored expectations. Current inflation expectations stand at 4.8%, down from a peak, which, alongside slowing employment, could justify Fed rate cuts if tariffs prove to be a transitory price shock.

Analysis

Why Tariffs Don’t Necessarily Mean Inflation STORY INLINE POST Tariffs definitely affect final consumer prices. But, as counterintuitive as it may sound, tariffs do not necessarily produce an inflationary phenomenon by themselves. In fact, Jerome Powell, chairman of the Federal Reserve System, recently stated that these taxes on imports may cause a one-off shock to prices. Most would agree that tariffs can be blamed for the still relatively high levels of consumer inflation experienced throughout 2025. From stockpiling inventories before tariffs took effect, to sourcing domestic suppliers and absorbing profit margin losses, firms have been working to cushion the impact of higher prices on their customers. Despite these efforts, final prices for goods, which are internationally tradable, unlike services, have increased. The Consumer Price Index (CPI) helps illustrate this point. Within the CPI’s core index, the subcategory of goods shifted from a clearly deflationary trend — showing negative annual rates between January 2024 and March 2025 — to accelerating to 1.5% in August. Meanwhile, services inflation moderated to 3.6%, down from 4.1% in January. As a result of these opposing forces, core inflation’s annual growth has remained relatively steady, slightly above 3%. The contrast between goods and services prices offers a first clue as to why tariffs aren’t necessarily an inflationary phenomenon. Before going further, let’s recall that inflation is broadly defined as a general and sustained increase in prices. So, if rising goods prices force families to cut spending on services — due to budget constraints — and service prices eventually decline, we are witnessing a relative change in prices, not a general and sustained increase. This is typical of supply-side shocks, as opposed to demand-side shocks, which tend to have broader and more persistent effects on prices. That said, a supply-side shock can still lead to an inflationary path. History has shown that, at the very least, inflation expectations must remain anchored to avoid a general and sustained spike in price levels. If firms and households believe that long-term inflation will stay close to the Fed’s 2% target, they are likely to overlook short-term price shocks. This means firms won’t raise prices every time they face an increase in one or two production inputs; instead, they’ll absorb most of the shock. Likewise, workers won’t continually demand higher wages if consumer inflation deviates slightly from “normal” levels. Inflation expectations for the next year (according to the University of Michigan consumer confidence report) stood last month at 4.8%, way below the 6.5% peak seen during April’s tariff-scare, but still above the average seen in the 10 years preceding the vcoivd-19 pandemic. So, as long as inflation expectations continue to decline, we shouldn’t sound the alarms. This helps explain why Chair Powell says tariffs may have a non-lasting effect on prices. Moreover, as employment slows rapidly, it makes sense to consider rate cuts even if inflation remains somewhat above the Fed’s target. To what extent should the Fed adjust its monetary policy stance? That will depend entirely on the evidence supporting the idea that tariffs are merely a one-off shock to prices — and on how much weakness the labor market shows in the coming months. The prevailing view, supported by Federal Reserve Chair Jerome Powell, frames the impact of tariffs as a one-off price shock rather than a driver of sustained inflation. This is evidenced by recent CPI data showing a divergence between goods and services prices. While the core goods sub-index reversed from a deflationary trend to a 1.5% annual increase in August 2025, services inflation simultaneously moderated to 3.6% from 4.1% in January. This counterbalance has kept core inflation relatively stable, slightly above 3%, suggesting a relative price change as consumers adjust spending rather than a broad, persistent inflationary event. The primary risk to this outlook is unanchored inflation expectations; while one-year expectations have receded to 4.8% from a peak of 6.5%, they remain above the pre-pandemic average. Consequently, the potential for Fed rate cuts remains viable, particularly as the labor market shows signs of slowing rapidly. The Fed's future policy will be contingent on incoming data confirming both the transitory nature of the price shock and the degree of weakness in the labor market.

Key Decisions for Investors

• Investors should closely monitor upcoming labor market reports, as further pronounced weakness could serve as the primary catalyst for the Federal Reserve to initiate rate cuts, benefiting fixed-income and rate-sensitive equities.
• Track the University of Michigan consumer confidence report, as a continued decline in one-year inflation expectations from the current 4.8% level would reinforce the 'transitory' inflation narrative and could lessen the case for holding aggressive inflation hedges.
• Consider the divergence between goods and services inflation when evaluating sector exposure; consumer services may face headwinds from budget-constrained households, while the outlook for goods producers depends on their ability to absorb or pass on tariff-related costs.