Do Tariffs Really Cause Inflation?

Hello and welcome, everyone, to this month’s market update for February 2025. My name is Steve Latham, and I am the chief investment officer for Bernick Wealth Management. Today, we’re going to be talking about the link between tariffs and inflation.

First, just to lay the baseline, we believe tariffs, at least under the current administration, are being used more as a negotiating tool than intended to be implemented over a long period of time.

Certainly, the implications of tariffs implemented over a long period would differ significantly from those used temporarily as a negotiating tactic. We’re operating under the assumption that they are a negotiating tool at this point, at least as it relates to how tariffs could impact inflation today.

How Tariffs are Implemented

In today’s presentation, we want to cover how tariffs are actually implemented. This will give us an idea of what is happening at the baseline from a consumption and business standpoint. Then, we’ll discuss how that could impact inflation over a longer period.

Now, if we look at this infographic, we see a standard route of trade from a foreign company, or a foreign country.

If a Mexican company creates a widget for $100 and the United States wants to purchase that widget for $100, the Mexican company earns that $100, and the U.S. company pays that $100. Ignoring any profitability metrics for simplicity, if that company then sells the widget for $100 to the consumer, the consumer spends $100.They own the widget, and the company recoups that $100, resulting in a net-neutral overall transaction. That’s how trade is generally done, without obstructions from tariffs or other regulatory entities.

Tariffs in Action

Now, let’s add a tariff to the equation to see how that works. The Mexican company still sells the widget for $100 to the United States company.But if we introduce a 25% tariff, the United States company collects that tariff. The Mexican company doesn’t pay the tariff; rather, it’s the company importing the widget into the United States. So, the U.S. company pays $100 for the widget and collects $25 for the tariff.

That $25 is ultimately collected from the United States consumer, the end-user and the purchaser of that product. The tariff cost is passed along because the company won’t absorb the cost. They’ll pass it along to the next user in the supply chain, often resulting in a higher cost of goods, as the consumer pays the tariff to recoup the $25 absorbed by the company.

Now, where does that $25 go? The company doesn’t own it. They have to pay it to the government. The $25 goes straight to the government as a tariff tax. The United States consumer still spends $125 on the widget, and the company has $100 to pay for the base product.

The base widget. That is how the supply chain works when we introduce a tariff.

Inflationary Impact

Now, as we can see, if widget prices go up because of a tariff, that’s technically inflation, inflationary to the tune of the tariff’s percentage. That applies to only that one product. If the consumer is stretched, which they aren’t in today’s environment, but they certainly don’t have as much money as they did a couple of years ago, instead of paying $125 to buy dinner and other goods and services, they may only be able to afford dinner because the product cost is higher, and they can’t spend on other goods and services because they’re putting more money into the higher-cost product. That means inflation is centralized to tariffed products. If there’s a broad sweeping tariff, then yes, that could be inflationary across the entire economy. Again, we’re currently assuming that tariffs are temporary.

So, we don’t believe inflationary pressures will result from tariffs.

Money Supply and CPI

However, if we’re looking more broadly at what’s causing inflationary pressures, we have to look at how much money is flowing through the economy. One way to view that is through the money supply. The chart here depicts how much money is in consumers’ pockets.

It’s technically termed M2, showing how much money is being lent from banks and used for consumption: buying goods and services, building homes, doing home renovations, and so on. We saw the money supply spike during the COVID years.

That was due to the stimulus from the federal government and monetary policy allowing for the easy flow of money. Now, the orange line overlaying the M2 money supply represents the Consumer Price Index, or CPI, a common measure of inflation. Inflation lags an increase in the money supply. Shortly after, we saw inflation spike to almost 9% towards the beginning of 2022.

Of course, inflation has come down since then, but our current concern isn’t so much tariffs as the re-acceleration of the money supply. We’ve seen the money supply continue to increase because banks are still flush with cash, and consumers are in a relatively healthy space. They’re lending more, so more money is entering the market, potentially causing broader inflationary pressures.

Now, we haven’t seen that in the CPI yet. However, as of today’s recording, we saw the January CPI, which ticked up a little hotter than expected. But that’s just one data point, and we won’t rely on a single data point. We need to see a broader trend.

What is more concerning from our standpoint, again, isn’t tariffs but an increase in the money supply, which could potentially cause a re-acceleration of inflation.

Monitoring Inflation

That’s what we’ll be looking for from an inflation standpoint. Of course, there are other factors at play that we’ll also be watching.

It’s certainly a dynamic environment, and we’ll be keeping our ear to the ground to stay abreast of everything we believe is important, not only from an inflation standpoint but from an overall market standpoint. If you have any questions about what we reviewed today, or anything else, please feel free to reach out. We’d be happy to answer them. Thank you.