The Fed’s tariff balancing Act - don’t get too ‘bullish’ on US rates in 2026

Despite the ongoing legal and political wrangling it is increasingly likely that higher tariffs in the US are ‘here to stay’. The Trump administration’s increase in tariffs have therefore provided a unique opportunity to witness first hand how a material ‘across the board’ increase in tariffs can impact a large advanced economy. 

Surprisingly in the year post the announcements, though there are signs of adverse impacts on growth in particular sectors and a modest increase in inflation, the overall impact has been relatively benign. 

 This has allowed the markets to produce a ‘collective sigh of relief’ and feel more comfortable pricing in rate cuts from the US Federal Reserve (“Fed”) over 2026. Yet this may be premature as signalled by the Fed’s recently published discussion papers regarding the impacts of tariff increases.

To understand why complacency may be premature it is important to take a step back and consider the dynamics involved in determining the impacts from changing tariffs. When assessing the impact of tariffs the overall structure of the economic system is a key determinant. In turn when considering the structure of an economy the three key economic characteristics which determine overall impacts can be thought of as :

• Nature of product and market structure of imports (e.g. essential versus discretionary and competitive versus monopolistic)
• Availability and viability of access to alternatives/substitutes (e.g. domestically or internationally)
• Prevailing economic conditions.

It is the interaction of these characteristics which influence the structure of the economic system and determine the degree of tariff ‘pass-through’ and the ‘responses’ to that pass-through.

In turn both the ‘nature of product and market structure’ as well as ‘availability and viability of access to alternative/substitutes’ will differ based on the type of expenditure. Accordingly, to understand the dynamics it is useful to distinguish between two main expenditure transmission channels namely consumption and investment. 

Usefully for the US economy the significance of each type of expenditure transmission tunnel is roughly the same. This arises as on the one hand consumption expenditure makes up a far larger share of US economic activity at around 70% of GDP, by comparison investment expenditure at around 20% of US GDP is materially smaller. 

On the other hand the import content of consumption expenditure is materially lower at around 14% compared to around 40% for investment expenditure. So while consumption expenditure is around three times that of investment expenditure its import content is around one third that of investment expenditure. The result being that overall both channels are equally important when determining the impact of tariffs on economic activity and inflation.

Distinguishing between consumption and investment expenditure is important as the degree of ‘pass through’ and timing of that ‘pass through’ is likely to differ materially. Consumption expenditure is likely to be far more competitive with a greater access to alternatives/substitutes compared to investment expenditure. 

Put another way it is easier for the consumer to shift from an imported biscuit to domestically produced biscuit than it is for the domestic biscuit manufacturer to shift its manufacturing machinery from imported to domestic sources. 

Further the impact or pass through of tariffs on the consumption channel is likely to be faster than the investment channel. This follows as investment involves longer term planning and implementation as tariffs effectively raise the cost of capital. 

The effect is that the pass through via the investment channel will take longer to flow through the system. The difference in timing or lags becomes significant when considering the path over time by which the ‘pass through’ of the impacts from tariffs impacts on growth and inflation.

An important caveat is that isolating and quantifying the impacts from tariffs on output and inflation is difficult given the lags involved and the potential that both variables can be impacted by other factors. That said the US Fed has recently undertaken modelling of the potential impacts which are significant as they give an insight into their thinking at this point in time. 

Turning to the results from the Fed modelling, the initial response to tariffs will be a slowdown in activity, which is driven by two dynamics namely (a) pay back for the a initial pull forward of purchases aimed at front-running tariffs and (b) increased uncertainty over the impacts associated with the change in policy which will delay longer term decisions. 

So the initial response is that both consumers and firms reduce spending until there is more clarity on future trade policy. The result is that ironically the initial increase in tariffs may act as a brake on the economy resulting in an initial increase in the unemployment rate together with the drop in inflation. It is with respect to this initial response where the approach to implementing the tariff policy will potentially have the most impact. 

A clearly communicated consistent policy towards implementing tariffs will reduce the level of uncertainty thereby reducing the initial impact of the brake. Needless to say an inconsistent ad-hoc approach to introducing such a policy will have the opposite effect. It is fair to say that the current administration’s approach to implementing tariffs clearly falls into the latter camp.

Over time, the impact of tariffs flows through the economy as consumers adjust spending habits and firms adjust their supply chains. The unemployment rate returns to its original level or even declines slightly, whereas inflation picks up and relative to the scenario where tariffs remain unchanged. 

The magnitude of these impacts, as modelled by the US Fed, suggest a decline of inflation at the time of a tariff change is 10 bps (one- tenth of a percentage point) for a 1% increase in tariffs, which would imply 1 percentage point decline for a 10% increase in tariffs (see Figure 1). 

By year one, the reduction in inflation dissipates, then inflation surges about 10 bps per 1% increase in tariffs over the next two years, an effect that slowly starts to wane by year four. By comparison the contemporaneous impact of tariffs on the unemployment rate is relatively muted, with an increase in the first year of about 10 bps per 1% change in tariffs. That is, a 10% increase in tariffs would be expected to raise the unemployment rate by 1 percentage point. The unemployment rate then settles back down by year two and declines slightly over the next two years.

Significantly the modelling suggests that the inflationary pressures in the first 12 months following the increase in tariffs are likely to be very muted. The inflationary impacts will build over time and are not fully felt until 2-3 years after the introduction of tariffs.

Further complicating the quantification of the impact of tariffs on the economy is the final consideration and that is the “prevailing economic conditions”. “Prevailing economic conditions’ impact via two ways with the first being a direct channel influencing the the absolute magnitude of ‘pass through’ from tariffs. The key to determine the absolute level of ‘pass through’ is whether economic growth is robust or depressed when tariffs are introduced, or put another way, whether there is a positive or negative output gap; i.e. growth is above or below trend at the point tariffs are introduced. 

Evidence from past experience suggests that the response of both output and inflation to increases in tariff is more dramatic during periods of economic expansion; i.e. there is a positive output gap. This follows logically as during periods of rapid expansion there is greater capacity for importers and manufacturers to pass on higher prices to the end consumer. When tariffs increase and the economy is enjoying good times, the medium‐term loss in output tends to be higher as is the increase in inflation. 

By contrast tariff increases during recessions are more likely to have a mildly stimulating effect. Any stimulatory impact however is dependent on the response of other countries to the change in tariffs; i.e. retaliatory tariffs can overwhelm the modest positive impact on output.

The second impact from “prevailing economic conditions’ is an indirect channel that being via the Feds ‘policy reaction function’. As with many central banks the Fed has the dual mandate to achieve stable prices via an inflation target of 2% while promoting full employment. 

The weight which the Fed places on each of these objectives within its mandate is part of what is often termed their ‘policy reaction function’; i.e. how the Fed responds to deviations from their policy objectives. This ‘policy reaction function’ is not static but in turn evolves based on prevailing economic and financial conditions. At a general level this evolution can be thought of as shifting the ‘policy reaction function’ towards a greater focus on inflation during periods of strong growth or positive output gap and towards full employment during periods of economic stagnation or decline.

So what are the implications from the ‘prevailing economic conditions’ at this point in the cycle? Taking the output gap as estimated by the Federal Reserve of St Louis the US is operating at the highest positive output gap since the 1980’s (see Figure 2).

Such a large positive output gap is likely to strengthen the magnitude of the potential impact on inflation arising from the introduction of tariffs as producers have greater scope to push price increases onto end buyers. Acting as a potential counterbalance is the impact on the Fed’s ‘policy reaction function’, where the weight attached to any depression of economic growth is reduced and that applied to inflation is increased. 

The result is likely to be more restrictive monetary policy as the Fed focusses on the greater risk posed by inflation which will not become obvious for a couple of years. Indeed this dynamic may go some way to explaining the current tension between the White House and the Fed. Specifically the White House wants lower rates to counter the near term depressing effects of tariffs while the Fed is naturally inclined to be more focussed on maintaining higher rates to offset the higher inflation likely further down the track.

Results from Fed modelling suggest that a tariff increase creates a material uplift in inflation during good economic conditions which is only felt after 2-3 years. Accordingly, the relatively muted impact to date is not inconsistent with Fed modelling. 

This is not however a reason for the Fed to be complacent. When an economy is operating at or close to its highest level of capacity utilisation in the last 20+ years the Fed is likely to be more sensitive to increases in inflation rather than declines in economic activity. Against such a backdrop a more conservative assessment of Fed policy may be warranted over the next year or so as the objective of managing inflation risk moves more to the fore of its ‘policy reaction function’.  

This heightened focus on inflation risk will reduce the scope for rate cuts or make any rate cuts on the back of political pressure relatively short lived. An implication for bond investors is that, after the 2025 rally, it may pay to be more cautious regarding longer duration US interest rates going into 2026 with the potential that higher yielding bond markets such as Australia may start to outperform.

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