Higher tariffs are often thought to present a problem to monetary policymakers at the Federal Reserve (Fed). Tariff shocks raise prices and reduce output and employment, which seems to push in opposite directions from the perspective of the Fed’s dual mandate to stabilize prices and maintain full employment, creating challenges for the Fed in crafting a response. Reflecting these concerns, the word “tariff” appears 36 times over 18 pages in the latest Minutes of the Federal Open Market Committee (FOMC). But the “problem” of tariffs for monetary policymakers has been well understood for quite some time, and solutions to this problem already exist both in the economics literature and in the practical toolkit that central bankers have been using for many years. In essence, the solution is to adjust measures of inflation to remove the effects of changes in tariffs and other tax rates or employ a policy target, such as nominal GDP growth, that obviates the need for making such an adjustment.
Flexible inflation targeting (FIT) emerged as best practice monetary policymaking around the world beginning in the 1990s. Around the same time, economist John Taylor introduced his now-celebrated monetary policy rule, which provides a strikingly elegant and eminently practical guide for implementing FIT. The Taylor rule prescribes a setting for the federal funds rate target equal to its long-run neutral rate (often called “r-star”) plus 1.5 times the deviation of inflation from its 2 percent target and 0.5 times the deviation of output from its long-run, or potential, level. The last term in the rule, involving the output gap, makes the inflation-targeting regime “flexible,” by allowing the Fed to pursue modest stabilization objectives for output and employment, as called for by the dual mandate, while at the same time preserving long-run stability in inflation.
Shocks from the macroeconomy’s supply side are sometimes said to expose the vulnerable Achilles’ heel of both FIT and the Taylor rule. But FIT have long agreed that adjustments to the rule are needed to accommodate supply-side changes, and such adjustments can be readily made. It is widely understood that changes in world oil prices, tariffs and other taxes on consumption, and similar disturbances require one-time changes in the level of prices that allow households and businesses to adjust efficiently to these shocks in a free-market economy. The “inflation” that is targeted under FIT and a Taylor rule refers, by contrast, to the longer-run growth rate of prices that, according to Milton Friedman’s famous dictum “is always and everywhere a monetary phenomenon.”
In their book, Inflation Targeting: Lessons from the International Experience, former Federal Reserve Chair Ben Bernanke and his co-authors speak directly about the need to distinguish between these two types of changes when they emphasize that under FIT the targeted price “index should exclude … one-time price jumps that are unlikely to affect trend or ‘core’ inflation—for example, a rise in a value-added tax or in a sales tax.” Along these lines, economists at the Bank of Japan describe how their targeted measures of inflation are routinely “adjusted to exclude the estimated effects of changes in the consumption tax rate.” Fed Governor Christopher Waller explains, similarly, that “tariff are one-off increases in the price level and do not cause inflation beyond a temporary surge.” Thus, as he notes further, “standard central banking practice is to ‘look through’ such price-level effects as long as inflation expectations are anchored.”
On reflection, therefore, changes in tariffs present no special challenge for a central bank pursuing FIT through a Taylor rule. All that is necessary is that the measure of inflation appearing in the rule be adjusted to remove the transitory effects of one-time price level changes, a task that, as noted above, is routinely performed by economists at the Bank of Japan and surely can be successfully replicated by economists at the Fed, by subtracting estimated one-time tariff pass-through effects on the price level from the observed inflation rate. Researchers at the Harvard Business School pricing lab (https://www.pricinglab.org/tariff-tracker/) are already using high-frequency data to estimate the effects of tariffs on consumer goods’ prices. Economists at the Fed could use those estimates as an input to their own adjustments.
An even simpler alternative approach to solving the “problem” of supply shocks that many economists outside the Fed recommend simply focuses on targeting nominal GDP. The advantage of this approach is that it does not require an estimate of one-time pass-through effects on prices. Instead of making use of the Taylor rule, it replaces an analysis of the separate inflation and output-gap terms in the rule with the targeting of a single aggregate: the deviation of nominal GDP growth from a growth path consistent with the Fed’s 2 percent inflation target (for example, the Fed might view a growth path of 4 percent as appropriate, implying a real GDP growth rate of about 2 percent).
Because nominal GDP growth decomposes naturally into a weighted sum of inflation and real GDP growth, this approach retains the appealing properties of FIT and the original Taylor rule, allowing the Fed to pursue modest short-run stabilization objectives for the real economy even as its preserves longer-run stability in inflation. And because shocks to aggregate supply, including but by no means limited to increases in tariffs, tend to move output and prices in opposite directions, with little or no effect on nominal GDP growth itself, targeting the growth path of nominal GDP inherently avoids the problem of one-time tariff-related price pass throughs. Hence, the modified nominal GDP-targeting variant of the Taylor rule approach also makes clear that tariff-induced price pressures require no monetary policy response. Mercatus Center Scholars David Beckworth and Patrick Horan call this the “two-for-one deal” offered by nominal GDP targeting: it makes it easy for central bankers like Governor Waller to look through the one-time effects of increases in the price level and keep their focus on intermediate-term trends in inflation – the growth rate of prices – where it belongs.
In addition to adopting a proper targeting approach, central bank communications also play a crucial role when navigating supply shocks. In his comments cited above, Governor Waller anticipates a concern that has been raised by others both inside and outside the Fed. The “looking through” approach will fail if, in response to the one-time jump in the price level, private expectations of intermediate-term inflation adjust adaptively upward. Indeed, this unanchoring of inflationary expectations will then confront monetary policymakers with an even more painful tradeoff: either accommodate higher inflationary expectations with a more expansionary policy that does move intermediate-term inflation upward, or try to hold the line with contractionary policy and risk recession.
But this turns out to be another argument for, not against, making monetary policy according to a flexible inflation targeting rule like one of the two approaches discussed here – that is, either by a Taylor rule, modified by adjusting the targeted rate of inflation to remove the effects of tariffs, or by targeting the growth path of nominal GDP. The best way for a central bank to maintain its credibility and keep intermediate-term inflationary expectations anchored is to make consistent reference to a monetary policy strategy that will succeed in stabilizing intermediate-term inflation, even when confronted with the challenges of adverse supply shocks. And this sort of approach to communication is exactly what a rule-based approach is meant to achieve. Indeed, if the Fed had been following a transparent and systematic flexible inflation targeting rule for the past two years, it could have avoided the upward jump recently observed in some measures of expected inflation.
Thus, there’s just no need for FOMC members to keep worrying so much about tariffs. They can easily keep their focus on stabilizing inflation over the intermediate-term with reference an appropriately-adjusted Taylor rule or by tracking nominal GDP. But the monetary policy reaction to tariff shocks will work best if instead of wringing their hands about complexity, they make the simple adjustments needed in a transparent manner.
