Is the Fed Wrong About Trump's Tariffs?

The debate over Donald Trump’s tariffs reveals a fundamental conflict: are they a one-time price shock the Federal Reserve can ignore, or a genuine inflationary threat that justifies high interest rates? The answer hinges on whether the Fed believes its own models or its fears about public psychology, creating a high-stakes collision between the goals of monetary policy and a potential new wave of industrial policy.

Key Insights

Tariffs Aren't Inflation, They're a Tax: The Core Argument Against the Fed's Caution

Oren Kass: "...economists actually, for the most part, if pressed on this question, will admit that tariffs are not inflationary. The definition of inflation certainly as it is relevant to a central bank setting monetary policy concerns an ongoing increase in the overall price level. If you choose a specific policy that by design makes a one time change in the price of certain things, that is not inflation..."

The central argument from critics like Oren Kass of American Compass is that the Federal Reserve and many mainstream economists are mischaracterizing the economic nature of tariffs. He contends that tariffs, like a value-added tax (VAT) or a carbon tax, induce a one-time adjustment to the price level of specific goods, not the kind of sustained, broad-based price increases that define true inflation. In this view, a central bank's mandate is to fight ongoing inflation, not to counteract a deliberate, one-off policy choice designed to alter relative prices.

Kass argues this mischaracterization is not an honest mistake but a politically motivated tactic. He suggests that an ideological opposition to tariffs has led many economists to weaponize the term "inflation"—a politically sensitive issue—to undermine the policy. The implication is that the Fed, by citing tariff-driven inflation as a reason to keep rates high, is not acting as an independent arbiter but is instead allowing political bias to cloud its monetary policy judgment, effectively working against a politically ratified agenda.

The Fed's Own Models Contradict Its Current Stance

Anna Wong: "So back in 2018, in one of the FOMC meetings, Fed staff were studying why aren't tariffs as inflationary as they had forecasted... the conclusion is that if inflation expectations are anchored, there is no point in responding to the tariffs."

The Fed’s current cautious stance appears to contradict the lessons from its own analysis during the first Trump term. According to Anna Wong, Bloomberg's Chief U.S. Economist and a former Fed staffer, internal Fed models in 2018-2019 showed that tariffs on intermediate goods were short-lived and could even become deflationary after a few quarters. The models concluded that as long as inflation expectations remained anchored, the optimal monetary policy was to "look through" the tariff shock and not raise rates.

So, what changed? Wong identifies two key intellectual shifts within the Fed. First, there is a palpable uncertainty about whether inflation expectations are still truly anchored after the recent bout of high inflation. Second, the Fed seems to be embracing newer trade models which conclude that tariffs, particularly on intermediate goods, can be persistently inflationary by damaging productivity. This internal conflict—between its own historical models and a new, more pessimistic framework—is central to the Fed's current paralysis and its decision to err on the side of caution.

The Unanchored Elephant in the Room: Why the Fed Is "Afraid of Its Own Shadow"

Anna Wong: "I think in fact inflation expectations are not very well anchored... because of those not very well anchored inflation expectations, they couldn't cut."

The entire debate hinges on the stability of inflation expectations. If the public and markets believe inflation will return to 2%, a one-off price hike from tariffs is unlikely to cause a chain reaction of wage demands and further price increases. However, if expectations are fragile, that same shock could be the spark that ignites a wage-price spiral. Wong argues that the Fed's actions—holding rates high despite subdued data—reveal a deep-seated fear that expectations are not well-anchored, even if their official communications suggest otherwise.

This creates a credibility problem. The Fed's own policy mistakes, which allowed inflation to run hot for an extended period, may have contributed to this very fragility. Critics like Kass argue the Fed is now using a problem of its own making as a justification for a policy that counteracts the administration's goals. Wong frames it as an internal inconsistency: the Fed can't simultaneously claim expectations are anchored while acting as if they are on a knife's edge. This dilemma is why the Fed appears overly cautious, unable to cut rates for fear of unleashing the inflation it failed to contain just a few years ago.

The Data So Far: Services Disinflation is Winning the Battle Against Tariff Hikes

Anna Wong: "We have seen both airfares and hotels more than offset the tariff pass through so far. So on net the CPI has still been very subdued in the past four months."

While the debate rages on hypotheticals, the real-time data presents a more nuanced picture. Anna Wong’s team estimates that for every 1 percentage point shock from tariffs, there has been an approximate 0.3 percentage point pass-through to consumer prices, concentrated in discretionary goods like household appliances and electronics. However, this inflationary impulse has been more than neutralized by a significant drop in services prices. A "consumer sentiment shock" following the tariff announcements has dampened spending on travel and hotels, causing prices for airfares and lodging to fall.

The net result is that headline inflation has remained subdued. The Fed’s justification for holding rates steady is its forecast that this dynamic will soon reverse. The central bank anticipates that once companies run through their stockpiled inventories by July and August, they will be forced to restock at higher tariff-inclusive prices, finally unleashing the feared inflation surge. This makes the next two months of CPI data the critical test that will either validate the Fed's caution or prove it was needlessly hawkish.

Notable Quotes

Oren Kass: "I think economists... have shown over the last couple of years to have a very deep ideological opposition to tariffs that has quite toxically interfered with their ability to engage in public debates on the issue."

Anna Wong: "...if a public institution demonstrates in the past five years that it had made so many policy mistakes and misjudged forecast, then it probably is not enough to say that, well, most of the economist profession says this, so we are not alone in making this mistake."

Oren Kass: "I would love to see an increase of wages because we see investments in that lead to rising productivity. But with respect to other macroeconomic effects... I really do think the right way to analyze tariffs is the way that we analyze other taxes."

Market Implications

The discussion highlights a market caught between two powerful and conflicting forces: the Fed's restrictive monetary policy and the potential for a disruptive industrial policy under a second Trump administration. This creates significant uncertainty and several potential pathways for investors.

• The Decisive Data: The most immediate and actionable takeaway is the focus on the July and August inflation reports. If CPI remains cool as the inventory cycle turns, it would strongly suggest the Fed's fears are overblown. This could force a dovish pivot, triggering a rally in both equities (especially rate-sensitive tech and growth stocks) and bonds as the market prices in overdue rate cuts.

• The Policy Collision Scenario: A sustained period of tariffs met by a hawkish Fed creates a recipe for stagflation. In this scenario, high interest rates would choke off the very domestic investment the tariffs are meant to encourage, leading to slowing economic growth while prices remain elevated due to trade frictions. This would be a negative environment for broad market indexes, favoring defensive assets and commodities.

• The "Re-industrialization" Play: If the Fed ultimately chooses to "look through" tariff effects and cuts rates, it could provide a powerful tailwind for the "Trumponomics" agenda. This would be bullish for sectors poised to benefit from domestic investment and onshoring, such as U.S. industrials, materials, energy, and small-cap domestic manufacturers. The key variable is whether the Fed prioritizes fighting a potential inflation ghost or accommodating a major shift in fiscal and trade policy. Investors should monitor the Fed's language for any sign of a shift in its reaction function away from pure inflation-fighting toward a more balanced growth/inflation mandate.