Trump's border tax could trigger inflation, but don't expect an immediate reaction from the Fed

Economists are worried that Donald Trump’s plan to introduce a so-called border tax on imports could cause a spike in inflation, and rightly so.
The logic here is simple: Lots of goods consumed in the US are made overseas, from Mexico to China. Companies aren’t going to eat the tariffs Trump wants to slap on these — and so they will pass on the higher costs to consumers instead.

But the run-up in prices may not be as sweeping as some expect. It will apply only in select industries and likely be temporary, and that means the Fed may not have to respond at all.

Those expectations for inflation did push Treasury bond yields higher (reflecting expectations that interest rates would rise), at first. More recently though, they have retreated — a signal traders are not secure in the recovery’s durability.

Part of the newfound hesitancy among bond investors comes from an utter lack of clarity on a potential fiscal stimulus plan, a major source of recent stock market enthusiasm, which has seen major averages hit repeated record highs.

In the meantime, the Trump team is talking up the part of its economic agenda that many on Wall Street once tried to dismiss as bluster — a desire to aggressively pull back on existing trade agreements and treating allies and trading partners as adversaries.

Many economists fear this approach could lead to a damaging trade war, but the plan has also not yet been fleshed out enough for anyone to fully assess it.

Dovish Fed

Here’s what Deutsche Bank economists Matthew Luzzetti and Aditya Bhave had to say about the tax and its implications for inflation — and Federal Reserve policy by association.

“Although the dollar is expected to strengthen to offset some of the effects of the tax, we estimate that core inflation could rise temporarily by between 1.4% and 2.1%,” they wrote in a research note. Core inflation excludes volatile food and energy costs, and Fed officials see it as a good predictor of future overall inflation. “The impact on headline inflation would be slightly larger. Over time, the impact on inflation should be considerably more limited.”

“In terms of monetary policy, the border tax should tilt the outlook in a more dovish direction initially, as the Fed is expected to look through the upfront rise in inflation and focus instead on heightened uncertainty and risks to the economy from tighter financial conditions and weaker real income growth,” add Luzzetti and Bhave. “Beyond the initial reaction, the tax could be hawkish for the Fed at the margin, especially if the rise in inflation leads to an increase in long-term inflation expectations.”

The formal rotation of regional Fed officials on the policy-setting Federal Open Market Committee has made the FOMC more dovish this year. Still, US President Donald Trump will have a large say over the future direction of the Fed since he will get to make key new appointments in his first term.

If his picks make the Fed’s composition more hawkish, the central bank might take a more aggressive stance on any border-tax related spike in consumer prices. UBS economist Pierre Lafoucade says the Fed should not have to react in principle because “tax changes are one-off level shifts in prices and output, which the Fed should see right through.”

However, he warns, “we are late [in the economic] cycle and the tariff and tariff-like policies act like a demand shock — higher prices and output — which eliminate remaining slack. That reduces the Fed’s room for manoeuvre vis-à-vis its inflation and full employment objectives and the Fed is thus likely to tighten policy at least somewhat relative to a no fiscal policy change scenario.”

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