There has scarcely been a week since President Donald Trump took office when tariffs have not been debated in the domestic and international media. In a recent addition to this debate, Fox Business aired a segment calling the Fed’s recent decision to keep its rate target steady a sign that Wall Street and all the president’s critics are mistaken to be worried about tariffs.
The editorial is a good starting point to unpack several things that are wrong with the way the president’s defenders justify his tariff proposals. First, it’s strange to credit the rate decision and defend tariffs. Among the many reasons Chair Jerome Powell gave for the pause in rate cuts is the fear of inflation induced through tariffs. Second, Larry Kudlow’s defense of tariffs uses an unrealistic hypothetical:
If the price of a washing machine goes up because of a tariff, and a family goes out and buys the machine anyway at the higher price, that means they have less money to spend on other items.
The washing machine price will go up, but some other price or prices will go down. It might mean that family won’t buy a television set, or a computer, or something else. So, one price goes up, families have less to spend on another good, and that other price goes down.
But the overall consumer price index of 80,000 items does not change. That’s what makes it transitory.
Note that the hypothetical itself implicitly concedes that American consumers will be hurt by tariffs as they will have to forsake goods purchases that could have been made in the absence of trade restrictions. That problem aside, if Trump’s tariff proposals singled out just one or two individual goods, this hypothetical may have been a valid example of the administration’s (still bad) policies.
However, the tariffs currently in place are broad, country-wide tariffs on several major trading partners. And the coming addition of so-called reciprocal tariffs will be just as broad, if not broader. Under such conditions, tariffs do not simply alter a few relative prices as Mr. Kudlow claims because the prices of virtually all goods simultaneously increase, resulting in inflation. Of course, this inflation may still be “transitory” since it could just be a one-time increase in the price level, but how short-lived the increase is really doesn’t matter—the increase could be large, and it will negatively affect the real economy.
Tariff defenders are wrong on the economics of tariffs, but this Fox Business editorial also misses the mark on the nature of money and price interactions. To defend tariffs, Mr. Kudlow resorts to an oft-used but ill-understood tactic of claiming that nothing other than the increased supply of dollars can cause inflation. So, according to this view, it must be the Fed—the agency responsible for “printing” dollars—that causes all inflation. Mr. Kudlow claims:
The only way an individual price can lead to higher overall inflation is if the Fed turns on the printing press, or if the federal government goes on a spending binge. If that were the case, then overall inflation will go up, whether there are tariffs or not, because inflation is fundamentally a monetary problem.
At best, this passage is an incomplete assessment of Milton Friedman’s famous adage that inflation is always and everywhere a monetary phenomenon. But that misuse is nothing new, with the COVID-19-related inflation providing many recent examples. Many such critics draw spurious correlation from the quantity theory of money that provides the famous equation of exchange:
Price level (P) x Real output (Y) = Money supply (M) x Velocity of money (V)
On the surface, prices and money are proportionally related in the “PY=MV” equation. But that is only a cursory explanation. Of course, if Mr. Kudlow’s statements were true, real money balances—the money supply divided by the aggregate price level—would be a relatively flat line. This is because any increase in M (the numerator) would be met by a corresponding increase of P (the denominator), keeping the overall fraction approximately constant over time. Fed data show it is not. The direct relationship between M and P, hypothesized by many monetarists, rests on two assumptions—that the velocity of money (V) is constant and M has no effect on Y. The former is no longer true, and the latter is only true in the long run, not over the near term in which tariffs could affect the economy. Additionally, with several financial innovations since the monetarist school first proposed this model, it has become increasingly harder to classify “money” and easily define a “correct” measure of M.
In the business cycle sense of inflation, Friedman’s quote is best understood to imply that inflation is the result of a discrepancy between the uses and availability of money—too much money chasing too few goods. Of course, the Fed printing dollars and handing them out can result in too much money. But that’s not what the Fed does. Moreover, “too much” money could result from a shortage of goods caused by tariffs, as Mr. Kudlow’s hypothetical itself admits. In fact, as Cato research has shown, the majority of inflation away from its trend is caused by supply shocks, such as a reduction in supply caused by a tariff increase.
Again, flooding currency into circulation is not how the Fed conducts monetary policy. Through most of the past few decades, the Fed has relied on an indirect monetary mechanism, trying to influence the rate at which banks borrow reserves from each other and make loans in the private sector. The Fed did change its operating framework during the 2008 financial crisis, but it still tries to affect the real economy by influencing short-term borrowing costs. It is also true that Congress can go on a “spending binge,” and the Fed can help make that easier. But it’s a stretch to place all the blame on the Fed for that kind of policy or any inflation that results.
For months, folks in the media have debated the merits of Trump’s policies, most of which are based on the idea that middle-class Americans saw their income crater because of the free trade of goods and labor. But that story is dead wrong—middle-class Americans, and lower-income Americans saw solid income growth during the past several decades. And the justification for the president’s trade policies keeps getting stranger by the day and moving further away from anything recognizable as economics.
The truth is tariffs result in higher prices and fewer goods available for sale in the United States. The higher and more widespread the tariffs, the bigger the reduction in goods and the larger the price increases. These tariffs are a recipe for making Americans worse off, and the president’s defenders should leave the Fed out of it.