Fed researchers say tariffs actually lower inflation — because they’re a demand shock that slams employment and economic activity

A new study by San Francisco Fed researchers challenges conventional economic theory, concluding that tariffs lead to lower inflation, reduced economic activity, and higher unemployment in the short term, rather than increasing prices. The research suggests tariffs act as aggregate demand shocks by fostering uncertainty, eroding consumer and investor confidence, and depressing asset prices, evidenced by declining stock prices and increased market volatility. This counter-intuitive finding implies that current tariff policies, while potentially curbing inflation, could simultaneously weaken the economy and labor market, presenting a complex trade-off for policymakers and investors.

Analysis

A recent San Francisco Fed study challenges conventional economic theory, concluding that tariffs lead to lower inflation, reduced economic activity, and higher unemployment in the short term. Researchers Barnichon and Singh found tariffs act as aggregate demand shocks, moving inflation and unemployment in the same direction, contrary to predictions of standard models. This suggests a significant re-evaluation of tariff impacts on macroeconomic variables.

The study posits tariffs create uncertainty, eroding consumer and investor confidence, which depresses economic activity and puts downward pressure on inflation. Evidence includes declining stock prices and increased stock market volatility in response to higher tariffs. Historically, a 4-percentage-point tariff increase pre-WWII reduced inflation by 2 percentage points and raised unemployment by approximately 1 percentage point.

This research provides a counter-narrative to the Trump administration's stance, despite a creeping CPI since tariff implementation. While Fed Chair Powell anticipates a one-time inflation boost followed by cooling, the study implies a persistent drag on economic activity and employment. Recent tariff removals on commodities, driven by voter anger over affordability, highlight the political and economic pressures.

Despite some economic resilience, employment has slowed sharply, with September payrolls growing by only 22,000, aligning with the study's unemployment findings. The "moderately negative" sentiment and "uncertain" tone reflect the complex trade-offs, where lower inflation might come at the cost of a weaker economy and labor market. Investors should consider these nuanced effects on corporate earnings and consumer demand.

Key Decisions for Investors

• Investors should re-evaluate traditional inflation hedges, as tariffs may lead to lower inflation rather than higher, contrary to conventional wisdom
• Closely monitor consumer and investor confidence indicators, alongside employment data and asset price movements, to gauge the real-time impact of trade policies on aggregate demand
• Consider adjusting portfolio allocations to sectors less sensitive to demand shocks and trade policy uncertainty, given the potential for reduced economic activity and increased market volatility
• Recognize the heightened political influence on trade policy decisions, as voter sentiment regarding affordability can lead to sudden shifts in tariff implementation or removal, impacting market stability