How the Fed Should Deal With Tariffs

The Trump administration has radically reshaped American trade policy, enacting what may be the largest peacetime tax increase in history. On April 2, it announced sweeping “Liberation Day” tariffs on nearly all imported goods from every country. The plan includes a 10 percent universal tariff and higher “reciprocal” tariffs against countries with large trade surpluses with the United States. These changes pose a challenge for the Federal Reserve, which is tasked with maintaining low inflation and low unemployment. Critics warn that the tariffs will drive up consumer prices and fuel inflation.

In theory, the Fed should respond only to demand shocks, unexpected events affecting the demand for goods and services. Monetary policy is well-suited for stabilizing these sorts of disruptions. By contrast, a new tariff is a supply shock, an unexpected event affecting the economy’s ability to produce goods and services. The Fed should “look through” supply shocks because monetary policy cannot address them.

Unfortunately, big supply shocks, including tariffs, can temporarily affect the inflation rate, and it is difficult to distinguish between supply shocks and demand shocks in real time. To overcome this problem, the Fed should drop its current inflation-targeting approach and instead adopt a nominal gross domestic product (NGDP) target. NGDP targeting, never formally adopted by any nation but with a long historical list of advocates, shifts the Fed’s focus to the total dollar value of spending in the economy, rather than inflation alone. By targeting the overall growth of NGDP—the sum of all spending on final goods and services – the Fed can more effectively balance its congressional mandates of price stability and maximum employment.

Under a nominal GDP target, the Fed would be concerned only with keeping nominal GDP on a stable path. If nominal GDP rose above the target, the Fed would tighten policy. If nominal GDP fell below the target, it would loosen policy.

Milton Friedman and other free-market economists argued that the economy is too complicated to fine-tune‚ so the best monetary policy would follow a relatively simple rule to prevent the central bank from committing errors of commission. NGDP targeting fits that bill.

Under this regime, the Fed would no longer worry about whether changes in the inflation rate reflect supply shocks or demand shocks. Though inflation would rise and fall in response to supply shocks in the short term, Fed policy would still be anchored in the long term because nominal GDP growth is equal to inflation plus real (inflation-adjusted) GDP growth.

That would be an improvement over recent crises, where confusion over supply shocks led to monetary policy mistakes. For example, from January through April 2008, the Fed cut the federal funds rate—its main interest rate for adjusting monetary policy—several times, concerned with a slowing economy and rising unemployment. As the financial crisis intensified that summer and early fall, however, the Fed kept the federal funds rate at the same level amid worries about high inflation. By October, it was clear that a contracting economy was a much bigger problem than inflation and that the Fed had been misled by temporary price spikes coming from shocks to energy markets. Had the Fed not been so focused on inflation, it might have shifted to a more expansionary policy earlier.

More recently, in 2021 and 2022, the Fed struggled to understand the causes of inflation and committed errors in the opposite direction. Initially, the Fed believed high inflation was mostly the result of “transitory” supply shocks caused by the Covid-19 pandemic. By November 2021, with inflation still rising, Chairman Jerome Powell conceded that the term “transitory” should be retired, but the Fed was still slow to act. The outbreak of the Russia–Ukraine war in February 2022, an event that rattled food and energy markets, prompted the Fed to begin raising the federal funds rate only slowly in March. After inflation reached 40-year highs, the Fed then drastically raised the federal funds rate a full five percentage points between 2022 and 2023

The Great Recession and the recent inflation surge are both examples of the Fed falling behind the curve because supply shocks muddied the waters. The recent barrage of tariffs could create similar problems. NGDP targeting would sidestep these challenges. Moreover, NGDP targeting also helps with the Fed’s employment mandate because it indirectly stabilizes real GDP, which is closely linked to labor markets.

My colleague David Beckworth and I have shown what an NGDP targeting regime could look like in practice. In our analysis, an NGDP target would have prompted the Fed to act much more quickly both during the Great Recession and the inflation surge—perhaps mitigating both crises. The Fed should adopt a similar framework as it tries to navigate through the turbulent times ahead.

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