Will Trump's tariffs trigger high inflation in the US?

In an unusual intervention, US Treasury secretary Janet Yellen recently raised concerns that incoming president Donald Trump’s tariff policies might “derail” progress on bringing down inflation and in doing so “significantly raise costs for households”. Yellen also raised the issue of fiscal sustainability, saying that “the deficit needs to be brought down, especially now that we’re in an environment of higher interest rates”.

These two comments are unusual because Yellen’s Treasury has itself pursued a simultaneous path of raising tariffs and at the same time massively increasing government spending. In May 2024, the Biden administration announced a raft of new tariffs, including an increase in the levy on Chinese electric vehicles (EVs) from 25% to 100%, on Chinese semiconductors from 25% to 50%, and on Chinese solar cells from 25% to 50%.

Meanwhile, under Joe Biden and Yellen, the government deficit has increased enormously. If we exclude the two years of Covid spending in 2020 and 2021, we find that the previous Trump administration ran an average fiscal deficit of around 4% of GDP, while the Biden administration ran an average deficit of 6%.

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Could Trump's tariffs ramp up inflation?

It does seem rather brazen that given this record Yellen would raise concerns about tariffs and fiscal deficits under Trump. Yet at the same time, the economics of what she is saying makes sense. A large fiscal deficit means an increase in demand in the economy as the government pumps in more money than it takes out in terms of tax revenue. Meanwhile, raising tariffs squeezes out the supply of cheap goods available to satiate that demand.

The upshot is that the level of aggregate demand in the economy rises and the level of aggregate supply is constricted; or put another way, it increases the amount of money circulating while restricting the amount of goods that money can buy. You need not have a PhD in economic to know that this is a recipe for inflation.

The fact that Yellen will raise these concerns only when she is handing over the keys to the Treasury reflects America’s economic and political priorities. There is a general sense in the US that some sort of protectionist policy mix is the way forward. Anxieties about the rise of China are clearly discernible in the ever-rising tariffs being imposed on Chinese goods. Yet the average American is also deeply concerned about rising living costs.

US policymakers seem unable to grasp that they cannot have their cake and eat it when it comes to tariffs and deficits. They raise concerns about inflation, but also seem intent on advocating policies that will raise inflation. While the incoming Trump administration is not promising big spending giveaways such as Biden and Yellen’s ill-conceived – and bizarrely named – Inflation Reduction Act, it has committed to lowering taxes.

Lowering taxes without cutting spending has the same effect on economic demand as increasing spending. And with the Trump administration looking to outdo Biden on tariffs, the effect of the policy mix is likely to be inflationary. The effects of the Biden administration’s tariffs on inflation are already evident in the inflation data. US inflation has proven to be stickier than in Europe. European inflation dropped below the European Central Bank’s 2% target in September. Meanwhile, in October US inflation remained above 2.5%. It has yet to hit the central bank’s 2% target or fall below it.

Core inflation – stripped of volatile elements such as food and energy – tells a similar story. European core inflation fell below 3% as early as March 2024 and has since stayed there. US core inflation, however, has not yet fallen below 3%. October’s reading puts it at 3.3%.

There are also questions about whether inflation is even being measured properly. The official US inflation numbers peaked at 9.1% in June 2022. But a recent paper by a team led by former Treasury secretary Larry Summers shows that if inflation is measured in line with older methods, it peaked at around 18%.

The difference between the two measures is the inclusion of interest costs to consumers. These were removed from the index in 1983 to make it easier for central banks, which use interest rates to control inflation, to target the inflation rate. But Summers and his team argue that to understand what the actual cost-of-living increase feels like to the average consumer, interest costs must be taken into account.

Exogenous events and the impact on inflation

When economists try to think through how the economy is functioning, they consider the whole economy as a self-regulating system. When thinking through the basic determinants of inflation, we have considered the interaction of the demand side of the economy with the supply side. But we must also consider the impact on inflation of events that come from “outside” the system: “exogenous events”.

In recent years, exogenous events have been playing a much larger role in determining the rate of inflation than has been typical historically. Two of the largest drivers of the recent burst of inflation have been exogenous events: firstly, Covid and lockdowns; secondly, the war in Ukraine and sanctions.

When governments moved to contain the Covid outbreak they shut down a significant amount of economic activity through their lockdown policies. At the same time, they massively increased the amount of spending in the economy through their payments to those who could not work, which resulted in enormous deficit spending. This created a large inflationary upsurge in the affected economies.

The impact of the war in Ukraine was somewhat different. The war led to major disruptions in global energy markets as Western countries tried to shift away from buying Russian oil and gas. This led to a spike in the price of energy. Both producers and consumers need energy, so when these higher prices arrived, they were felt directly by consumers in the form of higher energy bills and also passed on by producers who embedded the higher energy costs they were paying in the prices of the products they were making. This created a “double whammy” that resulted in a major cost-of-living crisis in many countries.

Trouble and strife

Are there any exogenous events on the horizon today? The nature of exogenous events is that they are unpredictable. But there are a few risks that stand out. The first is geopolitical. While the war in Ukraine may be winding down – with Trump saying that he will end it within 24 hours – the conflict in the Middle East is only becoming more chaotic and unpredictable.

The collapse of Bassar al-Assad’s government in Syria has unleashed a wave of chaos and shifting alliances, the results of which won’t be known for a long time. But this event comes on top of an already unstable situation.

Arguably the biggest risk from the Middle East is a major disruption to global oil markets in the event of a conflict between Israel and Iran. In that case it seems almost certain that energy markets would be affected.

Scenarios range from attacks on energy infrastructure to the Iranians imposing a blockade on the Strait of Hormuz, through which 17 million barrels of oil pass every day (20%-30% of total global supply). The situation between Israel and Iran has seen a number of escalations in 2024, notably Iran hitting Israel with a barrage of ballistic missiles in early October and Israel responding by bombing major sites in Iran.

The Biden administration has made it a top priority to try to contain the escalating violence between Iran and Israel, but it has had limited success. With the collapse of the Syrian government, another point of instability has emerged for the Israelis and where things go from here is anyone’s guess. Trump is seen as more friendly toward Israel than Biden, so he might be more open to a broader conflict if this is what the Israelis feel they need to pursue.

The other potential exogenous event on the horizon for an incoming Trump administration is a fiscal crisis. In March 2024, headlines about a looming fiscal crisis in the US started to appear in the financial press. “US Faces Liz Truss-Style Market Shock as Debt Soars, Warns Watchdog”, said a Financial Times headline.

Fiscal foibles

“Companies Rush to Issue Bonds to Forestall Market Volatility Ahead of US Election,” the same paper noted a few days later. The reports highlighted the sheer size of the fiscal deficit in the United States, the burgeoning interest-rate payments and, most importantly, the fact that a potential Trump administration might scare the markets with its policies and trigger a fiscal event similar to the one Britain experienced when Liz Truss became prime minister and tried to push through a series of tax cuts.

Since then, there have indeed been fears that such a fiscal event might be possible when Trump becomes president next year. Yellen highlighted this once again, fretting about “fiscal sustainability” and the possibility of a sharp rise in borrowing costs. It is hard to ignore the political angle in these pronouncements.

The people highlighting the possibility of a fiscal event are often Democrats – and they seem to have been strangely unconcerned with the size of the fiscal deficit when Biden was engaged in a spending splurge. But the sad reality is that we now have to factor in the extreme political polarisation in the US and the possibility that it might play a role in provoking a potential crisis.

With a grim fiscal situation and a politically fractured body politic, the US appears to be running the risk of a fiscal crisis. But we should also add to this mounting illiquidity in the foreign market for Treasuries. Nervous about the future status of the US dollar, central banks around the world are snapping up gold, and this is creating a lack of foreign demand for Treasury bonds.

In the event of a fiscal crisis, the Federal Reserve would have to step in and buy bonds being sold down by foreign buyers. This would put downward pressure on the dollar and, in turn, upward pressure on inflation. As Trump enters the White House next year there are several inflation risks that might be on the cards. We will have to wait and see whether any of them become a reality.

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