Why tariff inflation, if it comes, won't be just a blip

I am a Tariff Man,” declares President-elect Donald Trump. But wait! Won’t tariffs cause inflation? Yes, say the Wall Street Journal and other mainstream commentators. No, says Scott Bessent, the hedge fund manager that Trump has picked to be Treasury Secretary. At most, he thinks tariff inflation will at most be just a blip.

Who is right? The inflation experienced after Covid-19 offers some clues. The supply-chain disruptions that set it off were only transient, but the resulting catch-up inflation had a distressingly long tail. Three lessons learned from that painful episode – which may have cost the Democrats both Congress and the White House – suggest that any inflation driven by tariffs on the scale Trump has promised will be more than a blip. 

Lesson 1: Inflation has both a demand side and a supply side

Start by dissecting Bessent’s Panglossian view, as revealed in a recent radio interview. “Tariffs can’t be inflationary,” explained Bessent, “because if the price of one thing goes up, unless you give people more money, then they have less money to spend on the other thing, so there is no inflation. … Inflation comes through either increasing the money supply or increasing the government spending, and that’s what happened under Biden.”

There is a smidgen of truth in this, but just a smidgen. Yes, inflation is caused by too much demand chasing too much supply. Yes, policymakers can moderate demand by using monetary and fiscal policy. But those tools works best if excess demand is the origin of the inflation in the first place. The post-Covid inflation was different. The latest studies show that demand played only a small role in the upward surge of prices that began in the winter of 2021. Supply-chain disruptions played a much larger role. Tariffs, too, would mostly cause supply-side inflation.

When faced with supply-driven inflation, whether caused by factory closings and shipping bottlenecks or by tariffs, it is not enough just to hold the line on monetary and fiscal policy. To fully control inflation, the Fed would have to substantially crank up interest rates, preferably while Congress cut spending and/or raised taxes. In that case, we might get the Bessent result in which decreases in some prices offset increases in others. But such a strategy would come at the cost of falling real output and rising unemployment – even a major recession. Not what Bessent had in mind.  

Could a new misery index help explain the election outcome?

In 1970 everyone was feeling bad about the economy. How bad? To put a number to the pervasively negative vibe, Arthur Okun created the “misery index:” the sum of inflation and unemployment rates.

But now everyone is puzzled. Why was the economic vibe of 2024 bad enough to get the Democrats thrown out of office? After all, Okun’s misery index for the quarter leading up to the election stood at just 6.8, which was actually a whisker below its average of 6.9 for the Trump years. What is more, it had been falling almost continuously for nine quarters after peaking in April 2022.

Already six months before the election, when Okun’s index was still at 7.2, Paul Krugman wrote that for most Americans, the answer to the question, “Are you better off than you were four years ago?” should clearly be, “Yes.” But Krugman ruefully added, “for reasons that still remain unclear, many seem disinclined to believe it.” What went wrong?

Maybe part of the problem is that we need a new misery index. Maybe the Okun version just doesn’t capture what makes people miserable these days. In the many postmortems asking what Krugman and many others might have been missing, four factors come up repeatedly. In what follows, I use them as the building blocks of a 21^st century misery index.