Maybe tariffs won’t be as inflationary as feared

2025Q2

Last quarter I promised myself I wasn’t going to a write another article about Trump.  However, given events, that has proven difficult to avoid.  Much of the focus in financial markets over the last quarter has been on “Liberation Day” and Trump’s efforts to shake up the world trade order.  I won't get into the rights and wrongs of that.   However, one of the consequences of the Trump tariff shock is a standoff between Trump and the Fed on the future path of interest rates.  Trump wants lower rates – he is a property developer after all.  The Fed is concerned about the potential inflationary impacts of the tariffs, particularly given the relatively tight labour market and, hence, are inclined to keep short-term interest rates high.

This article argues that that the tariffs mightn’t have as big an impact on CPI as expected and, that investors should try and look past the tariffs when assessing the medium term outlook for inflation.

To provide a frame of reference, the Yale Budget Lab estimated the liberation day tariffs would add around 2.3% to US CPI.   Given the walk back since – TACO anyone – the tariff impact on CPI will be even lower.

I would argue that the actual impact will be even lower still.  The key to this argument is that the tariffs are a tax and taxes lower growth.  Thus, the imposition of the tariffs will reduce GDP growth – for example, the same Yale analysis of Liberation day tariffs suggests a 0.5% hit to GDP growth (and 0.9% including tariffs announced pre Liberation day).

Lower income means lower spending.  For non-tariffed goods – such as services – which make up around 57% of the CPI basket – lower spending will have both quantity and price effects. That is, simple economics, tells us that sellers will cut prices to try and sustain volumes in the face of a fall in demand.

These lower prices have the potential to mitigate, on a second-round effect basis, the impact of tariffs on CPI.

A key market to focus on is housing.  This is a tremendously important driver of measured inflation.  For the statistics wonks out there, owner's equivalent rent makes up 24% of the CPI (and an even larger share of core CPI).  Owners equivalent rent is a proxy for housing costs for people who own their own home.  It is a proxy for the rent that an owner occupier would otherwise have to pay.   It is estimated by the Bureau of Labor Statistics based on passing rents. 

I would argue that lower growth/incomes will result in lower demand for housing and, hence, lower house prices and lower rents. 

There are two other Trump policy measures that are also likely to reduce demand for housing

• immigration/deportation policies.  Reduced population (or reduced growth) reduces demand for housing.

  
  

• big beautiful bill (higher deficits) and trade policies (reduced foreign demand for USD assets) are putting upward pressure on long term US bond rates.  Long term government bond rates are the risk free rate for pricing mortgages.  Higher mortgage rates, results in worse affordability and, hence, reduced demand.

The chart below shows the Owner's Equivalent Rent (OER) component of CPI.  The key feature of this series is that it is extremely lagging.   Because it is based on passing rents, which are only reviewed annually, it lags actual rental market dynamics by at least a year.  For example, the spike in rental demand around Covid only saw OER CPI peak in mid 2023.

To provide a real-time perspective on rents, the chart below shows Red Fin’s data on asking rents (eg the rent asked by landlords listing a property for rent).  Under this series, asking rent inflation peaked in January 2022.  Furthermore, post this peak, rents have actually been falling (albeit gently) since mid 2023.

I would expect that these dynamics will soon start to feed into owners’ equivalent rents (and broader rent metrics that drive the shelter component of the CPI). 

This would provide an offset, within CPI, to tariff induced inflation.

Thus, while I share many of the bond market’s concerns regarding the long-term sustainability of the US’s government finances – which has been reflected in trading outcomes for US government bonds – I am much more sanguine about the outlook for US inflation.  This could easily provide the Fed with room to cut short-term interest rates should the economic outlook weaken.