The surprising tariff lesson buried in inflation data

By Nir Kaissar

If the Trump administration’s tariff policies result in higher overall inflation, a scenario that will play out in the coming weeks, the question is who will pay for it. A surge in prices will presumably raise the cost of doing business. Less clear is whether and to what extent companies will pass on those higher costs to consumers.

Any inflationary impact from tariffs should first show up in the Producer Price Index, which reflects changes in the cost of producing goods and services sold to consumers. Over time, producer inflation is passed on to consumers and shows up in the better-known Consumer Price Index.

The PPI and CPI’s long history shows that the two are closely related. They’ve grown at roughly similar rates — the PPI by 2.8 per cent a year since 1913 through May and the CPI at a slightly higher rate of 3.2 per cent a year. Annual changes in the two indexes have also been highly correlated over that time (0.8, counting monthly).

The relationship was as strong during the past 30 years (0.81), marked by the increasing globalization of trade, as it was during the first three decades of the data series (0.79). That long and consistent history supports the intuition that in the long run, businesses do — indeed, must — pass on their higher costs to consumers.

Looking at shorter periods, however, the numbers tell a more nuanced story. The first thing that jumps out is that annual changes in the PPI have been twice as volatile as those of the CPI, as measured by annualized standard deviation. This suggests that businesses have routinely shielded consumers from much of the turbulence in producer inflation.

Notably, most of that shielding occurred when producer inflation spiked. The median annual change in PPI was 2.3 per cent since 1913. During 12-month periods when producer inflation was lower than the median, roughly half the time, CPI outpaced PPI more than 90 per cent of the time and by a median of 2.2 percentage points.

But when annual producer inflation was higher than 2.3 per cent it was just the opposite. On those occasions, PPI outstripped CPI more than 70 per cent of the time and by a median of 1.6 percentage points. The results are nearly identical when annual changes in PPI and CPI are compared on a six- or 12-month lag.

In other words, the higher the inflation, the more likely businesses were to absorb most of the higher cost, at least in the near term, and vice versa. One way to understand that divergence is that there may be a limit to how much price inflation consumers can digest at one time. It would explain why businesses seem to have little trouble passing on their own higher costs to consumers in normal inflation environments but struggle to do so when inflation spikes.

Companies may also have a strategic incentive to internalize cost surges given competing considerations of volume and margin. Raising prices would protect profit margins in the near term but could imperil them down the road if higher prices result in lower volume and market share. Passing on higher costs to consumers gradually might be a way to protect both, particularly if companies have margin to spare.

Fortunately, many big US companies do — the profit margin for the S&P 500 Equal Weight Index is near an all-time high and expected to grow this year and next.

That may explain why the stock market has been so sensitive to tariff news this year. The White House’s Liberation Day announcement was greeted with one of the worst two-day US stock market routs on record, while tariff delays were routinely celebrated with surging stock prices. The seemingly single-minded focus on levies makes sense if companies have the most to lose.

One countervailing consideration is that heightened inflation expectations may give companies more room than usual to raise prices. A notable outlier in the data is that during the hyper inflationary years of the late 1970s and early 1980s, CPI mostly kept pace with PPI despite double-digit producer inflation.

Businesses may have been able to raise prices more aggressively because consumers had come to expect big price hikes. Memories of the pandemic’s price surge are a big reason Federal Reserve Chair Jerome Powell has called for caution on cutting interest rates until the implications of tariffs are more clear. With inflation expectations for next year nearly double the long-term inflation rate, businesses may be able to push costs to consumers more quickly.

The PPI and CPI don’t overlap perfectly, so they can only be a rough guide to the way businesses and consumers navigate higher prices. But given the behavior of producer and consumer inflation during previous periods of surging prices, don’t be surprised if any tariff-related inflation is initially absorbed mostly by companies.