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.