Breitbart Business Digest: Why Tariffs Do Not—and Cannot—Cause Inflation

Cato Comes for Kudlow on Inflation and Tariffs

The notion that tariffs cause inflation has become a super-virus infecting the minds of President Trump’s critics, seemingly immune to the usual antibiotics of economic evidence and logic.

The latest outbreak comes courtesy of Norbert Michel and Jai Kedia of the Cato Institute, who argue that tariffs reduce the supply of goods and therefore drive up prices, resulting in inflation. They further suggest that Larry Kudlow, in a recent “riff” segment on his Fox Business show, is misapplying Milton Friedman’s theory that inflation is always a monetary phenomenon. But their argument is more a display of ideological hostility to tariffs than persuasive economic reasoning.

Readers of the Breitbart Business Digest are likely well-vaccinated against this mind-virus, but a bit of booster to this particular strain might help.

Inflation vs. Relative Price Changes

Let’s start with Kudlow’s central point: inflation and relative price changes are not the same thing. When tariffs increase the price of one product, consumers have less money to spend on other goods, exerting downward pressure on prices elsewhere. Tariffs rearrange prices within the economy; they do not cause a broad, sustained rise in prices across the board.

Here’s how Kudlow put it:

If the price of a washing machine goes up because of a tariff, and a family goes out and buys the machine anyway at the higher price, that means they have less money to spend on other items.

The washing machine price will go up, but some other price or prices will go down. It might mean that family won’t buy a television set, or a computer, or something else. So, one price goes up, families have less to spend on another good, and that other price goes down.

But the overall consumer price index of 80,000 items does not change. That’s what makes it transitory.

Research into Trump-era tariffs—including studies by economists at the Federal Reserve and the National Bureau of Economic Research (NBER)—found minimal pass-through into broad inflation. Any price increases that reached consumers were largely confined to targeted items, with prices elsewhere remaining flat or declining. Inflation under Trump’s first term was typically below the Fed’s two percent target. Kudlow’s point that tariffs alter relative prices rather than cause broad inflation is validated by this empirical evidence.

Tariffs Are Not Broad Supply Shocks

Michel and Kedia argue that broad-based tariffs can be inflationary even if tariffs on specific products cannot. But even broad-based tariffs covering multiple countries and goods affect only a fraction of the 80,000-item basket that makes up the Consumer Price Index (CPI). Just 15 percent of consumer spending is on imported goods, so even the broadest tariff could not raise all prices directly.

They go on to argue that tariffs act as supply shocks by reducing the supply of goods available, thereby putting upward pressure on prices. Here they are inviting readers to think of more familiar supply shocks like oil embargoes or natural disasters. But framing tariffs this way invites a misunderstanding of how tariffs actually work.

A genuine supply shock, such as an oil embargo or natural disaster, reduces productive capacity or makes essential inputs significantly more expensive across the entire economy. Tariffs, by contrast, reorganize production and consumption rather than destroying it. They shift demand from foreign suppliers to domestic producers or alternative trading partners. Global supply is not destroyed—it is redistributed.

Even when tariffs disrupt supply chains, market economies adapt. Production shifts, alternative sources are found, and the disruptions are temporary. This makes tariffs fundamentally different from true supply shocks that eliminate production capacity or restrict essential resources.

Tariffs do not uniformly increase firms’ marginal costs the way an oil shock might. In fact, one study published as a NBER working paper notes the direct effect of a tariff is akin to a drop in demand for the affected product (due to the price increase), rather than a drop in the producer’s capacity. This means the shock doesn’t propagate through the economy in the same way as, say, an energy shortage. Businesses facing tariffs may even cut their own prices to stay competitive, offsetting some inflationary pressure.

There’s also another important distinction to be made between an energy shock and a tariff: revenue from a tariff accrues to the treasury of the country imposing it . By contrast, in an oil embargo the higher prices amount to pure loss for the importing country with no compensating domestic revenue. Because tariff revenue can be spent, used to pay down debt, or deployed to cut other taxes, the net macroeconomic effect is nothing like what we expected from a simple supply contraction.

Inflation Is Still a Monetary Phenomenon

Michel and Kedia have the audacity to claim Kudlow misunderstands monetary policy by fixating on money supply.

Again, flooding currency into circulation is not how the Fed conducts monetary policy. Through most of the past few decades, the Fed has relied on an indirect monetary mechanism, trying to influence the rate at which banks borrow reserves from each other and make loans in the private sector. The Fed did change its operating framework during the 2008 financial crisis, but it still tries to affect the real economy by influencing short-term borrowing costs.

But this argument misunderstands how monetary policy works. While the Fed does not print currency outright, it creates money through its control over interest rates and bank lending. Lowering the federal funds rate encourages banks to lend more, thereby expanding the money supply through credit creation. Dismissing this as merely “indirect” misunderstands how monetary policy operates.

The Fed’s influence over the money supply is very real and direct, precisely because it controls the incentives for banks to create money. This is why cutting rates during a downturn is seen as stimulative—it’s designed to boost the money supply through lending, even if that process is mediated by the banking system.

Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” still holds.

The Velocity of Money Is Not Constant

Michel and Kedia also attempt to take on Kudlow’s argument about monetary policy by blowing smoke about the velocity of money. But here they betray a misunderstanding of how the money supply and the velocity of money actually operate. They argue that if tariffs reduce real output (Y), and the money supply (M) remains unchanged, then prices (P) must rise.

But this simplistic model ignores two fundamental realities:

1. Tariffs Do Not Necessarily Reduce Output (Y): Tariffs reallocate demand from foreign suppliers to domestic producers or alternative trading partners, and they effect only a small portion of the consumer purchases. Productive capacity is not destroyed. It is simply shifted.
2. Velocity of Money (V) Is Not Constant: Velocity is highly responsive to changes in consumer behavior and trade dynamics. If tariffs cause consumers to spend more on targeted goods, they spend less on others, slowing the velocity of money in those sectors. This mitigates price pressures elsewhere, contradicting Michel and Kedia’s assumption of a stable velocity.

Getting Over Tariff-Induced Inflation Illusion

Michel and Kedia’s argument collapses under scrutiny. They conflate tariffs with catastrophic supply shocks, misread how prices adjust across the economy, and fundamentally misunderstand how monetary policy actually works. Inflation is still a monetary phenomenon, not a tariff phenomenon. And Larry Kudlow’s critics are chasing phantoms.

The truth is simple: tariffs may shift prices, but they do not fuel a wildfire of inflation. To believe otherwise is to mistake a price adjustment for a monetary explosion. The Cato Institute should know better.

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