Tariffs, the Dollar, and the Fed

When the US imposes tariffs unilaterally—without retaliation from other countries—the US dollar strengthens. That’s because with tariffs in place, US consumers and businesses demand fewer imports, and so by extension demand less foreign currency (since foreign products are typically priced in another currency, which is necessary for buying them). Demand for the US dollar in contrast is less directly damaged, since in this scenario other countries are not retaliating with their own tariffs. US demand for foreign currencies declines while foreign demand for US dollars is unchanged. Another way to think of this is that the demand for US dollars goes up relative to other currencies. The upshot is that the value of the US dollar rises.

A stronger dollar has pros and cons for the US. On the one hand, it means imports are less expensive to US businesses and consumers, effectively offsetting some of the cost of the tariff. Economic evidence is that—again, in cases where the US imposes a tariff without retaliation—dollar appreciation can offset between 30-50% of the cost of the tariff for consumers, a meaningful amount, but far from the entire cost. On the other hand, a stronger dollar means that US goods and services are more expensive to foreigners, which means less foreign demand for US products. So even if other countries do not retaliate against American tariffs with their own, US exporters are still indirectly hurt by the stronger dollar. Another way to think of this is that dollar appreciation “shifts” some of the cost of the tariff from US consumers onto US exporters & manufacturers. This hurts US exporters and can lead to layoffs and cuts in investment.

Thus far, all of this has assumed no retaliation from other countries. What about when other countries do retaliate, as is likely? Foreign demand for US exports, and therefore the US dollar, is now being directly affected. If the retaliatory tariffs are perfectly proportional to those imposed by the US, then the net effect on the US dollar is neutral and there’s no dollar appreciation. That’s better news for US exporters—while they now face retaliatory tariffs from certain countries, they are no longer disadvantaged in all foreign markets by a stronger US dollar—but it’s worse news for US consumers who now have less purchasing power for imports to offset the cost of the tariff.

A tariff is a tax that puts upward pressure on the relative price of imports; domestic goods & services prices may also rise to take advantage of the cost increase to their competitors. This represents a one-time shift in the price level. Since a tariff hike means taxes have gone up, real (inflation-adjusted) after-tax income must, by definition, go down. How this happens depends in large part on how the Federal Reserve choses to respond to the imposition of a tariff.

The likeliest scenario, embraced by Federal Reserve officials themselves, is that the Federal Reserve would try to “look through” or ignore the price effects of the tariff. The rationale for this strategy is that the Federal Reserve’s target is in terms of inflation (the growth in prices), and a tariff does not mechanically affect price growth over the medium-run, just the price level (although a tariff could in theory have persistent inflationary effects, e.g. if it damaged supply chains). In this scenario, the Federal Reserve would not change its prior nominal interest rate trajectory in response to a tariff. The price level rises after a tariff goes into effect, nominal income is no higher, and so real income is lower as a result.

In reality, however, it may prove challenging for the Fed to distinguish between tariff and non-tariff price pressures. Neither CPI nor PCE decompose products into imports and domestic goods & services, for example. An alternative approach is that the Federal Reserve neutralizes the price effect of a tariff, tightening monetary policy (or easing less) in response. In the extreme, it tightens until the price level returns to its pre-tariff trajectory. In this scenario, the price level is no different, but nominal incomes fall due to higher interest rates. Real after-tax income is therefore still lower, despite the different strategy of the Federal Reserve. The take-away is that while there are different mechanisms for getting there, the trade-off of a tariff on real after-tax income is unavoidable.

A further complication arises if the economy is significantly weaker in the wake of a tariff. Lower demand means less price pressure and generally calls for easier monetary policy (that is, lower interest rates). So, after taking into account every economic interaction and dynamic, it’s possible tariffs could lead to a US outlook with lower prices and interest rates in the short-to-medium run after all is said and done. But it’s worth emphasizing that even if this happened, this outcome would be borne of economic weakness, not strength. As an extreme example, the Smoot-Hawley Tariff Act of 1930 enacted the second highest tariff in US history, yet there was still deflation (lower price levels) in the years immediately following its enactment. Today, economic historians broadly agree that the Smoot-Hawley tariff accelerated the damage to demand from the Great Depression and that these effects dominated the mechanical upward price level effects from the tariffs themselves.