How much inflation could tariffs add?

Wall Street economists finishing their 2025 outlooks are spending most of their time on tariffs. They have modelled a sixty per cent tariff on China, twenty-five per cent on Mexico and Canada and a ten per cent universal duty. Almost all of them conclude that prices will rise as supply is squeezed.

The scenarios come straight from the campaign trail and its aftermath. Donald Trump promised during the election a universal tariff on imports and steep duties on Chinese goods, and in late November he said he would impose 25 per cent tariffs on everything from Mexico and Canada on his first day in office unless both countries curbed migration and drug trafficking, along with an extra levy on China. The Mexican peso and the Canadian dollar fell on the announcement. Economists do not know how much of this will be enacted, so they have to model the full threat and work down from there.

What the models say

The consensus estimate is that the full set of tariffs could add between 0.8 and 1.5 percentage points to headline US inflation in 2025 and knock up to a full percentage point off real GDP growth. That combination would leave the Federal Reserve little room to ease. It would have to keep borrowing costs high even as the economy slowed.

How a tariff reaches the till

The mechanics are straightforward. A tariff is a tax paid by the American importer when goods cross the border. The importer can absorb it in lower profits, push the foreign supplier to cut its price, or pass it on to customers, and in practice it does some of each. Domestic producers competing with the imports then have room to raise their own prices, so the effect spreads beyond the goods actually taxed. America imported about $3.1 trillion of goods last year, so even partial pass-through of a broad tariff amounts to a large sum spread across household budgets.

Two forces soften the blow. The dollar tends to rise when tariffs are imposed, which makes imports cheaper and offsets part of the duty. Foreign exporters facing the loss of their biggest market may also cut prices to keep customers. The range in the economists' estimates largely reflects different assumptions about how strong those offsets will be.

Lessons from the first round

The tariffs of 2018 and 2019 offer the best evidence. Studies of that period found that American importers and consumers bore nearly all of the cost, with foreign suppliers cutting prices very little. The duties on washing machines were a vivid case: washer prices rose sharply, and so did the prices of dryers, which were not tariffed but are usually sold alongside them. Overall inflation barely moved at the time, because the tariffs covered a much smaller share of imports than the new proposals and because the economy then had little underlying inflation. Neither condition holds today.

The Fed's dilemma

The Fed has already started to adjust. At its December meeting it raised its median forecast for core inflation next year to 2.5 per cent and cut the number of rate reductions it expects, with Jerome Powell saying some officials had begun to factor in the possible effects of trade policy. Textbook advice is to look through a one-off rise in the price level caused by a tax. The trouble is that inflation has run above target for nearly four years, and officials fear that households and firms, having lived through that, will treat new price rises as a reason to demand higher wages and set higher prices.

Winners and losers

Domestic producers of protected goods, such as steel and some manufactured products, would gain pricing power. Retailers that rely on imports, carmakers with supply chains running through Mexico and Canada, and farmers exposed to retaliation would lose. Lower-income households, which spend more of their budgets on traded goods such as clothing and appliances, would bear a disproportionate share of the cost. Mexico and Canada, which send most of their exports to America, would suffer far more than the United States, which is why the threat carries weight as a bargaining tool.

The case against the gloom

The strongest counterargument is that the full package is unlikely to be enacted. Mr Trump has used tariff threats as leverage before, and the Mexican and Canadian governments have already offered concessions on border security. Exemptions for particular products, delays and negotiated deals could leave the eventual tariffs far below the modelled scenarios. Even if imposed, tariffs raise the price level once, and once the new prices are in place, inflation should fall back unless wages and expectations respond.

That is a reasonable case for the bottom of the economists' range. It is not a reason for the Fed to ignore the top.

What to watch

The first signals will come in the days after the inauguration on 20 January, when executive orders will show which tariffs are imposed, at what rates and on what timetable. Retailers' price-setting in the spring, surveys of inflation expectations and the Fed's March projections will then show whether the effect is spreading. Retaliation by China, Mexico or Canada would raise the costs for American exporters.

If the tariffs are imposed in full, 2025 will probably bring higher prices and slower growth together. Borrowers should not expect the Fed to come to the rescue while inflation is rising. The likeliest outcome is a partial package that still pushes inflation above the Fed's 2.5 per cent forecast by the summer, with lower-income households and import-dependent retailers paying first.