Breaking update: Tariffs, Inflation, and Interest Rates: Rethinking a Common Assumption.

Tariffs are typically viewed as inflationary.

By raising the cost of imported goods, the conventional wisdom holds that tariffs push prices higher for consumers and businesses, fueling broader inflation across the economy.

However, new research published by the San Francisco Federal Reserve Bank challenges this long-standing assumption.

According to the study, the sharp increase in tariffs imposed last year by the Trump administration may actually reduce inflation rather than increase it—an insight that carries important implications for monetary policy, including the case for interest-rate cuts.

At first glance, the idea seems counterintuitive.

Tariffs act as a tax on imports, and taxes generally raise prices.

Indeed, many companies initially respond to tariffs by passing at least part of the added cost on to consumers.

But the San Francisco Fed’s research suggests that this is only part of the story.

When examined across the entire economy, the broader effects of tariffs can work in the opposite direction, dampening inflationary pressures over time.

One key mechanism is reduced demand. Higher tariffs can slow economic activity by increasing uncertainty and discouraging investment.

Businesses facing higher input costs may scale back expansion plans, while consumers confronted with higher prices or economic uncertainty may reduce spending.

When overall demand weakens, firms have less pricing power, which can limit or even reverse upward pressure on prices.

In this way, tariffs can contribute to disinflation, particularly if they weigh heavily on growth.

Another factor highlighted by researchers is the impact on global supply chains and trade volumes.

Tariffs can reduce the volume of trade by making imported goods less competitive. While this initially raises prices in specific sectors, it can also lead to excess capacity elsewhere in the economy.

Domestic producers may struggle to fully replace foreign suppliers efficiently, leading to slower productivity growth and softer wage pressures—both of which can restrain inflation.

The research also points to financial market responses. Trade tensions and tariff hikes often increase market volatility and dampen investor confidence.

This can tighten financial conditions, even without changes in official interest rates.

When borrowing becomes more expensive or harder to obtain, spending and investment slow, again reducing inflationary momentum.

These findings have significant implications for monetary policy.

Central banks, including the Federal Reserve, typically respond to rising inflation by raising interest rates and to falling inflation by cutting them.

If tariffs are misinterpreted as inflationary when they are in fact disinflationary, policymakers risk making the wrong decision.

Instead of tightening policy in response to tariff hikes, the research suggests that interest-rate cuts may be a more appropriate response to offset the drag on economic growth and prevent inflation from falling too low.

This perspective does not imply that tariffs are beneficial economic tools.

Even if they reduce inflation, tariffs can still harm economic efficiency, disrupt trade relationships, and lower long-term growth.

Lower inflation achieved through weaker demand and reduced investment is not the same as healthy, productivity-driven price stability.

Nevertheless, understanding the true inflationary impact of tariffs is crucial for effective policy design.

In conclusion, the San Francisco Federal Reserve Bank’s research invites a reassessment of how tariffs affect inflation.

By showing that sharp tariff increases may reduce, rather than raise, inflation, the study challenges a deeply rooted assumption in economic policymaking.

For central banks, the message is clear: trade policy shocks should be carefully analyzed, not automatically treated as inflationary.

In the current environment, that analysis may point toward interest-rate cuts as the more appropriate policy response.