Four Ways Tariffs Contribute to Inflation

In recent months, economists have expressed cautious optimism, noting the containment of inflation after a challenging period. However, the looming threat of tariffs could jeopardize this progress and rekindle inflationary pressures.

Typically perceived as one-time price increases similar to specialized sales taxes, the impact of tariffs on inflation is more intricate and widespread. Analysts at UBS caution that the ramifications of tariffs extend far beyond an immediate increase in consumer prices, generating ripples that can exacerbate inflation through various channels.

Fundamentally, tariffs operate as taxes on imported goods, with the costs usually passed onto consumers. This leads to an initial surge in prices, which might appear to reflect a temporary change in the price level rather than the sustained inflation that concerns economists.

However, the true inflationary effect of tariffs is more complicated. A closer examination shows how tariffs can create profit-driven inflation, elevate wages, diminish market competition, and disrupt supply chains, all of which contribute to a prolonged inflationary cycle.

One notable effect of tariffs is their encouragement of profit-led inflation. When a tariff is imposed, consumers often anticipate a proportional increase in prices, believing a 10% tariff should result in a corresponding 10% rise in costs. However, since tariffs are applied to import prices rather than final consumer prices, the actual effect on retail prices should be significantly lower. For example, a 10% tariff on the import price—often much less than half the consumer price—would likely translate to an increase of less than 5% for consumers. Nevertheless, businesses frequently exploit the situation, raising prices beyond what is justified by the cost increase to bolster their profit margins.

Analysts at UBS highlight that this mechanism allows companies to disguise their motives under the guise of tariffs, resulting in inflation driven not by increased costs but by inflated profits. The resulting price increases, whether stemming directly from tariffs or opportunistic price inflation by companies, can have secondary effects on the labor market, leading to increased wage demands. As workers notice their purchasing power diminishing due to higher prices, they are likely to pursue wage increases to match the rising cost of living. When tariffs affect a wide range of products and sectors, such wage demands can spread across both traded and non-traded sectors of the economy.

As businesses respond to higher labor costs by further raising prices, the economy risks entering a wage-price spiral, where rising wages and prices perpetually reinforce one another. UBS notes that this dynamic can become entrenched, complicating efforts to reduce inflation once the cycle begins.

Beyond immediate price and wage impacts, tariffs can also have a detrimental effect on market competition, further fueling inflation. By creating barriers to imported goods, tariffs lessen the competitive pressures that typically help to keep prices stable. When foreign companies are subjected to punitive tariffs, they may be dissuaded from entering or maintaining a presence in markets burdened by such protectionist measures. Even after the tariffs are lifted, the competition damage may be lasting, as companies may hesitate to reinvest in markets with a history of protectionism. This diminished competition allows domestic companies greater flexibility to raise prices without the risk of being undercut by less expensive foreign alternatives. Analysts contend that this reduction in competition can cultivate a more inflationary environment, granting firms greater pricing power in the absence of external pressures.

In addition to these demand-side factors, tariffs also generate inflationary pressures on the supply side by disrupting global supply chains. Modern economies depend on integrated supply chains, with raw materials and components crossing multiple borders before being assembled into finished products. When tariffs raise the cost of imports, this increases input costs for manufacturers, which are then passed onto consumers. This impact can be particularly severe in industries with complex and global supply chains, such as electronics and automobiles. Analysts emphasize that supply-side inflation due to tariffs can be especially harmful because it not only elevates prices for individual products but also hinders the efficient flow of goods across borders, leading to bottlenecks and additional cost escalations throughout the economy.

Overall, these dynamics reveal that tariffs can create more than just a temporary spike in prices. They interact with broader economic forces, amplifying inflationary pressures through both direct and indirect channels. By enabling profit-led price increases, driving wage demands, suppressing competition, and disrupting supply chains, tariffs contribute to an ongoing rise in prices that transcends their immediate effects. As policymakers assess the potential benefits of protectionist measures against the inflation risks, they must remain vigilant about these complex interactions.

The discussion surrounding these inflationary risks is particularly pertinent in a global economy that is still recovering from earlier inflationary periods. While tariffs may be a tool for protecting domestic industries or increasing government revenues, their wider economic implications could reignite inflation just as stability seems to be within reach. For governments and central banks, effectively managing these risks will be crucial in preserving economic stability and avoiding a resurgence of the high-inflation environment that many seek to leave behind.