Tariffs and inflation: Clarifying the complicated

Federal Reserve Chairman Jerome Powell stated on April 16, 2025, that President Trump's tariffs would likely lead to higher rates of inflation. He made this claim before an audience at the Economic Club of Chicago. This somewhat gratuitous statement must be examined in light of sound economic theory: Do tariffs actually cause inflation?

Basic Economics

Classic economics defines three primary sources of government funding: taxation, debt, and inflation. To tax is to levy fees on income, sales, property, and other activities to raise revenue for expenditures. Second, borrowing enables governments to finance operations through future tax revenues. Lastly, expansionary monetary policy may increase the money supply relative to the output of goods and services, raising prices and reducing the currency's value. As Milton Friedman famously argued, this phenomenon is known as inflation.

Powell, It's the Balance Sheet

The Fed has three means of fulfilling its dual mandate:

1. Changing the target short-term overnight rate

2. Setting reserve requirements

3. Open market operations

While changes to interest rates and reserve requirements influence borrowing and liquidity, the most potent tool recently has been the Fed's large-scale asset purchases in the open market. These purchases are financed with previously non-existent money, described in Latin as ex nihilo, or "out of nothing." When the Fed expands its balance sheet in this way without a corresponding increase in the production of goods and services, the result is inflation.

The Expanding Money Supply

In February 2020, the U.S. money supply stood at $4.1 trillion. By March, the COVID-19 pandemic had spread rapidly across the world. In a whirlwind of uncertainty, many businesses shut their doors, millions were laid off, and the U.S. economy fell into recession. As a counter-cyclical measure, the Federal Reserve expanded the money supply from $4.1 trillion to $8.97 trillion in about two years. Consequently, U.S. inflation, as measured by the Consumer Price Index (CPI), surged from 1.4% in January 2021 to 9.1% by June 2022, on an annualized basis. After several months of elevated inflation, the CPI began to decline as the Federal Reserve reduced its balance sheet by $2.24 trillion, bringing it down to $6.73 trillion as of mid-April 2025. America has a monetary problem.

Ballooning National Debt

From a fiscal perspective, the U.S. national debt surpassed $1 trillion for the first time in its then-205-year history at the end of President Reagan's first year in office in 1981. The deficit expanded significantly during the Reagan years as the administration pursued tax cuts, strengthened Cold War defense spending, and battled inflation. By the close of the Clinton administration, the national debt had grown to $5.68 trillion. President Clinton achieved a budget surplus in his final year, driven largely by spending reforms and the post-Cold War reduction in defense outlays.

Government spending rose dramatically during the George W. Bush and Obama administrations, particularly through the 2008 financial crisis, bringing the debt to $19.6 trillion by the end of Obama's tenure. Under President Trump, the debt increased further, reaching $26.95 trillion, largely due to emergency spending during the COVID-19 crisis. The debt expanded by another 85% during the first terms of Presidents Trump and Biden, ultimately reaching $36.3 trillion as Biden left office. Notably, nearly $9.5 trillion of that was added during the Biden administration, despite strong economic growth of 5.7% for his first calendar year in office.

Rebutting Tariff-Spurred Inflation

This historical context in both fiscal and monetary policy reveals the flaw in Chairman Powell's assertion. He warned that if the Trump administration continues to impose tariffs on key imports and the economy slows or contracts, the result could be inflation—or worse, stagflation.

However, what Powell described is not technically inflation, at least according to economists like Milton Friedman. Inflation, historically, is primarily driven by an increase in the money supply, not by fiscal policy or trade regulations. While tariffs and taxes can lead to higher prices, these increases are typically offset by a slowing economy or quickly reversed when such measures are lifted.

President Trump's Strategy

President Trump's interests in strengthening the U.S. economy and reinforcing the nation's global leadership are on target. His push for tax reform, regulatory rollback, and more balanced federal spending reflects a prudent economic approach. Simultaneously, his administration continues to enforce border security and uphold a foreign policy centered on peace through strength.

The United States must also respond decisively to China's economic behavior. This includes addressing:

A) Violations of World Trade Organization (WTO) rules;

B) Chinese firms listed on U.S. exchanges that fail to meet U.S. Generally Accepted Accounting Principles (GAAP);

C) Intellectual property theft;

D) Currency manipulation, which artificially boosts Chinese exports and disadvantages U.S. manufacturers.

If the current tariff policy generates hundreds of billions in tax revenue, the U.S. economy may still achieve robust growth by year-end. The potential drag from tariffs could be counterbalanced by the stimulative effects of lower taxes, deregulation, and more disciplined federal spending.

Conclusion

While a more traditional free-market approach would be preferred—centered on stable monetary policy, tax cuts, deregulation, and devolving power to the states—it is evident that China's aggressive trade and military posture demands a firm response. Whether one agrees with Trump's tariff strategy or not, it represents a deliberate effort to defend America, defend domestic industries and improve labor conditions for American workers. Ultimately, history reveals that tariffs do not inherently cause inflation and should not alone justify restrictive monetary policy. Nor should tariff policy spark the uncertainty and instability that exists in today's global economy, especially with allies that have stood with America through thick and thin, helping us build the freest and most prosperous global economy in the history of the world.

This article was originally published by RealClearMarkets and made available via RealClearWire.