Tariffs Part 2: An Impossible Balance

This is Part 2 of a multiple part series.

• Tariffs Part 1: An Introduction
• Tariffs Part 2: An Impossible Balance

As a reminder, this post (Part 2) and the previous one (Part 1) in this series are intended to be relatively generic, providing non-partisan information on tariffs and the pros and cons thereof. While Part 1 is not technically a prerequisite, you will need to have read it or generally have some base knowledge of tariffs and their effects on an economy.

Additionally, we cannot account for every complex variable in an economy, so this discussion is intended to provide a relatively high-level, generalized analysis centered on outcomes that are highly likely based on established economic principles.

I also am not currently talking, in these posts, specifically about current policy proposals or discussions. This post does, however, consider a hypothetical issuance of a large-scale tariff program and its implications on the current economy.

Due to the length of Part 1, I did not delve into at least two additional important consequences of tariffs with the level of detail necessary to further round out our understanding of the potential severity that tariffs — especially large-scale ones — may or may not cause.

Both of these outstanding issues on my mind are particularly pernicious, in my opinion, but I will only tackle one here for now - as to attempt to keep the length of this reined in.

The image above is a bit much, but I thought it was funny.

An Impossible Balance?

Defining the hypothetical

Summary

In the case of the issuance of a large tariff program, such as described; inflation rises, job loss occurs, and the economy slows. This is referred to as stagflation.

For the purpose of this article, let’s imagine our (USA) government issuing large tariffs - large, in this case, meaning a high percentage on the majority (or all?) imported goods.

The mechanics are covered in Part 1, however, this course of action would likely cause relatively severe:

1. Inflation.
2. Overall job loss in the broader economy.
3. Overall reduction in aggregate demand (growth slows or turns to loss).

This is a particularly challenging situation, sometimes colloquially referred to as stagflation.

Although the reduction in demand puts downward pressure on prices (disinflation), this effect is dampened by the inflationary effects of the tariffs. Perhaps, so much so, that inflation keeps rising - especially with particularly high tariffs on a high enough amount of goods.

And so, imagine this incredible situation that we would be in here - rising unemployment and increased inflation. An economy can handle relatively moderate rises in one - but not typically both at once without intense problems.

The Federal Reserve’s Task

Summary 

The Federal Reserve is tasked to balance unemployment and prices as best it can, via monetary policy. The primary mechanism discussed is the raising and lowering of interest rates. Raising them tends to slow the economy and inflation, while lowering them tends to stimulate the economy and raise inflation.

One of the most important roles of the Federal Reserve (aka ‘The Fed’), the U.S. Central Bank, is managing monetary policy.

This is the dual mandate of The Fed:

• Maintaining the maximum sustainable employment while maintaining a stable inflation rate.
• Trying to maintain stable prices.

So - how does The Fed do this? Well a few ways - but one of the main levers is adjusting interest rates. I won’t go into detail on the specifics there. At a high level - changing the interest rates can be used to indirectly affect prices (inflation / disinflation) by adjusting them in the following way:

Raising interest rates helps reduce inflation by slowing demand in the economy, but this comes at the cost of slowing growth & higher unemployment. Conversely, lowering rates can stimulate the economy but fuels inflation.

The mechanisms through which these actions cause these changes is not material here, but if you’re interested let me know on Bluesky and perhaps I will write about that at another time.

The Impossible Balance

Summary 

Considering stagflation, The Federal Reserve is placed into the harsh reality of being forced to raise interest rates, in order to reduce inflation.

So, going back to our situation in the economy after the issuance of the hypothetical large tariffs. Rising inflation and rising unemployment.

In this case, what could or would the government do to counteract these issues through fiscal policy, outside the Federal Reserve’s actions? Introduce stimulus programs or cash via Congress, and inflation rises. Cut spending to reduce aggregate demand, and more jobs are lost.

Similarly, what is The Federal Reserve to do, here? It is between a rock and a hard place; but nevertheless - forced to act.

Considering that The Fed would certainly prioritize avoiding runaway inflation - it would either leave rates where they are for longer or even more likely — raise them further.

Then What?

Summary 

The economy, in the state of stagflation, and considering The Fed's action - raising the interest rate, is thrown into an even deeper recession in order to attempt to get things back on track over the long term.

Well, to summarize the series of events, from the beginning:

• The damaging effects of these large-scale tariffs would place the larger economy into a state of stagflation
  • A challenging situation in which unemployment and inflation are rising while economy is slowing.
• We explored how The Fed would now be stuck in a tough position, basically forced to raise rates to curb inflation.

As discussed earlier in The Federal Reserve’s Task section, raising interest rates helps dampen inflation but also slows the economy, leading to job loss.

In conclusion, the first-order effects of the tariffs are severe enough, but The Fed would then be compelled to push the economy into a deeper recession to set it on a path for long-term recovery. Such a recovery might take years, depending on the magnitude of the stagflation and the effectiveness of coordinated policy responses such as fiscal stimulus.

Why would a government, with a stable economy, purposefully risk throwing itself into long-term economic chaos immediately after suffering (and recovering from) high inflation? Why issue such large and sweeping tariffs and commit an unforced error of this magnitude? Surely you wouldn’t, right?