As featured in the Nashville Business Journal.
The more there is of something, the less people will value it. If the supply is greater than the demand, the price will go down. That is, unless there is a government barrier which prevents that from happening. It doesn’t matter if it is grains of sand, gold bars or dollar bills.
This should make sense. However, what doesn’t make sense is whether tariffs are inflationary. Let’s just say it can be a gray area for many.
Tariffs as a Cost of Doing Business
After all, given the global nature of most industrial supply chains, it is virtually impossible for companies and consumers to avoid paying the administration’s tariffs either directly or indirectly. They are now a cost of doing business, and someone has to eat them.
Obviously, that means more money going out for the same product or service. If that isn’t inflation, what is? Right?
Perhaps.
President Ronald Reagan was quoted saying: “Common sense told us that when you put a big tax on something, the people will produce less of it.” If he were making the same speech today, he would probably say “people will consume less of it.”
This is just basic economics. The more something costs, the less people will consume. It doesn’t matter the reason for the price increase. It could be the weather, increased consumer demand or even government interference. Most consumers have a finite supply of money and have to make their purchasing decisions accordingly.
For instance, assume you have $15 for lunch, and the cheeseburger value meal at your favorite restaurant costs $13. What do you do? You get it, right? However, what would happen if the government were to slap a 50% “unhealthy food” tax on it? What would you do then?
I am not sure either, but I do know you won’t be getting the cheeseburger value meal at your favorite restaurant — that is, unless the place slashed the price of the value meal.
But is this inflationary? Clearly, the meal now costs more for the consumer. So, in that way it is inflationary indeed. However, is this inflation something the Federal Reserve can control by manipulating the supply of money in the financial system?
That is a trick question.
The Fed’s Dilemma
Yes, the Fed can control this sort of inflation. However, in order to do so, it would have to tighten the supply of money in the economy to make it more valuable. This would cause deflation on the underlying products and services. In our cheeseburger example, the price of our meal would have to come down to $10.
In reality, what would happen to the supply of value meals if the restaurant owner can only charge $10? More than likely, the supply would go down. Obviously, this logic, when spread across the entire economy, could lead to a slowing in overall activity.
As a result, the Federal Reserve is in a thankless position.
- It can ignore the impact tariffs might have on consumer prices and potentially make the problem that much worse by cutting the overnight rate.
- Or it can keep monetary conditions tighter for longer in order to keep consumer prices under control.
What do you do? Run the risk of higher prices or slower growth?
The Policy Divide
For monetary policy purposes, I believe the Fed should treat tariffs as a tax, which they are, and not just another cost of doing business along the supply chain. Would it try to drain money from the system if Washington were to enact a national sales tax? Has it done so over the years when marginal tax rates have fluctuated? Changes to the gasoline tax? That sort of thing?
While I don’t know for certain, I suspect at least one person at the Fed would consider those things part of the government’s fiscal policy and not monetary policy. If I worked there, I know I would.
As such, I certainly hope the Fed starts cutting the overnight rate no later than its meeting on September 16 and 17. The longer it waits to do so, the greater the risk to the overall economy. This is because tariffs might make things cost more for the consumer, but they don’t increase the supply of money in the economy.
To that end, they are both inflationary and deflationary at the same time.
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