The U.S. economy is comprised of 340 million people sitting atop a gross domestic product of $30 trillion. So it’s no surprise that the economic health of such a massive country is, at times, hard to gauge. We economists track the myriad measurements of jobs, inflation, growth and so on, but there are times when the data is as confounding as it is clarifying.
This is one of those times. Inflation is particularly confusing right now: For months, economists and retailers have claimed that the tariffs will spike prices, yet government measurements of inflation keep coming in cool. The job market looks good on the surface but there is trouble under the hood. And now we have a new worry: another round of geopolitical conflict in the Middle East, which, as usual, is pressuring oil prices, still one of the most critical prices in our economy.
That all creates a dense fog of data. But with the right fog lights, it’s possible to illuminate what’s going on out there — and offer an educated guess about how the Federal Reserve might be reading the moment.
The job market, though still solid, is showing some cracks at the lower depths.
Starting with inflation, we learned last week that the consumer price index (CPI) for May came in at 2.4% annual rate, slightly below expectations and with little evidence of tariffs boosting prices overall. It’s not that the tariffs were nowhere to be seen in the data. Some prices associated with imports spiked in the month, including major appliances (think refrigerators) and toys. But others, including apparel and new cars, were fine.
How can this be?
First, the tariffs’ impact can be seen in other data, including historically huge spikes in imports and inventory buildups as firms try to front run the import taxes. The revenue on these taxes collected by customs agents has nearly tripled, from $8 billion per month before President Trump launched his trade war to a record $24 billion in May. To be very clear, this is money paid by U.S. importers. Contrary to administration claims, exporters are not “eating the tariffs.”
OK, then why isn’t any of this showing up in the CPI?
Here’s where the fog lights come on. I mentioned above that importers tried to front run the tariffs by stocking up their inventories. Well, to the extent that firms are selling out of those inventories, they may not yet be compelled to fully pass on the higher costs. As The New York Times reported, the inventory buildup “created a buffer for sellers to offer discounts, such as around Memorial Day, and generally hold off on raising prices until those stockpiles run out.”
There’s another important dynamic going on in the background. When the pandemic hit, many consumers had more savings than usual due to both generous government support and the fact that the pandemic forced them to temporarily stop spending on face-to-face services, travel, restaurants, etc. This made them less sensitive to price increases. Retailers were explicit about this, bragging on earnings calls about raising prices without losing customers. At the time, many firms didn’t just raise prices enough to only cover the higher labor and material costs but also to pad their profit margins. That padding gives them another buffer when it comes to passing on the costs. Firms avoid doing so by cutting into their elevated margins but, again, only for so long.
Tariff price pressures and potentially higher energy costs still are in the pipeline.
In other words, there’s a strong likelihood that temporary factors are, for now, holding back price passthrough. Once those forces fade, we should see more of a tariff bump in the inflation data. Because we’re sailing in uncharted waters, I can’t give you a date, but I’d guess within the next 3-6 months.
Before I get to the implications of all this for the Fed, we must check in with the job market and the oil price.
The job market, though still solid, is showing some cracks at the lower depths. Specifically, the uncertainty generated by the trade war is leading employers to mostly hold onto their current workers but be very cautious about hiring new ones. We’re not seeing layoffs but hiring is down and “continuing UI claims” — people stuck on unemployment Insurance — are up.
Finally, Israel’s attack on Iran led the oil price to jump to about $72 a barrel last Friday, up from about $65 the week before. The oil price slipped back a bit Monday as markets are actively trying to figure out how disruptive this conflict will be. But should it escalate — for example, if Iran decides to start causing trouble in the Strait of Hormuz — it will push up gas prices and overall inflation.
Amid all this, Trump has, as usual, been pressuring the Fed and its chair, Jerome Powell, to lower interest rates. Vice President JD Vance joined in last week, writing “the refusal by the Fed to cut rates is monetary malpractice.”
As long as inflation is staying cool and the job market is softening, why wouldn’t the Fed lower rates, and give consumers and employers a bit more confidence about the future? Well, because of the tariffs, I don’t think the Fed will lower rates anytime soon. I suspect its members' view is the same as mine: tariff price pressures and potentially higher energy costs still are in the pipeline. As long as the economy is still in good shape, the Fed can remain in wait-and-see mode. After all, when you’re driving through the fog, no matter how good your fog lights, the safe play is to drive slowly.