What impact will Trump's tariff plan have on consumer price inflation? It's challenging to determine an exact number, despite the Fed policymakers increasing their consensus estimate of core PCE by 0.3 percentage points for 2025. Nonetheless, if Trump's tariff plan is fully implemented, the effect will be considerably greater than the Fed's estimate, and "experienced" inflation will exceed "reported" inflation.
As of now, Trump has enforced 25% tariffs on steel and aluminum imports, is contemplating new tariffs on lumber imports, particularly from Canada, new tariffs on imports from Canada and Mexico, and plans to announce a new series of reciprocal tariffs on a wide range of imports on April 2.
The direct effect of these tariffs on consumer price inflation (CPI) would be significant, but the full effect will still be dampened somewhat due to technical or statistical factors. Several decades ago, the Bureau of Labor Statistics (BLS) reclassified owner-occupied housing from a commodity/product to a service item, known as the owner's equivalent rent index. This reclassification reduced the weight of non-food and energy commodities from 46% to 19%. (Interestingly, the weight of used vehicles is ten times that of appliances).
As a result, tariffs on steel, aluminum, and lumber will certainly raise the costs of housing construction. However, this increase won't appear in the CPI since housing is presently categorized as a service item, despite how unusual that may seem. Therefore, the reported core inflation will be lower than the actual inflation experienced when real housing costs are considered.
Over the past year, the prices of commodities excluding food and energy were unchanged. If tariffs increase the prices of these items by 3% to 5% over the coming year, core inflation could rise by half to a full percentage point, assuming other factors remain constant. Further increases in core inflation are likely due to rising food prices, as certain targeted tariffs affect food imports. Thus, the effect of tariffs on reported inflation could easily be three or four times larger than what Fed policymakers anticipate.
In mid-March, the University of Michigan's consumer sentiment survey showed that the one-year inflation index jumped to 4.9%, the highest since 1993. Thus, people see and expect more inflation even though policymakers do not.
If inflation surpasses 4%, the Fed would struggle to label this rise as "transitory," considering their recent error of describing pandemic-driven inflation as "transitory," which turned out to be more significant and prolonged than anticipated.
From a policy standpoint, inflation exceeding 4% would make the current monetary policy stance too easy, given the official target rate is between 4.25% and 4.5%. Will the Fed raise the official rate to curb the rise in inflation, similar to its delayed action following the pandemic-induced inflation surge?
Financial markets believe the likelihood of this is almost zero. However, what truly has no chance is the fed funds rate being cut by 100 basis points in the next year or so, as policymakers predicted in March, if inflation moves higher as people expect it will.
If the Fed's forecasts about future inflation are inaccurate, financial markets are probably mis-priced since they often align their expectations with the Fed's statements. Investors should note that the Fed has often been more wrong than correct in predicting future inflation!