Viewpoint
October 24, 2025 | 15:00
Inflation Comes Down to Supply and Demand
Economics
Economics
Economics
Economics
Economics
Economics
Inflation Comes Down to Supply and Demand |
| We have been on inflation watch all year, bracing for the Administration’s new tariff policies to create a classic negative aggregate supply shock on the economy. A supply shock occurs when production costs, or availability of goods, suddenly change, shifting the aggregate supply curve. When tariffs are imposed, imported inputs and goods become more expensive, and firms relying on those imports face higher costs and produce less at any given price, i.e., the aggregate supply curve shifts to the left. Domestic producers of the tariffed goods may also increase their prices as they no longer have to compete against cheaper imports. This leads, over time, to higher inflation and lower growth—the classic symptoms of a negative supply shock. Tariffs can also spill over to the demand side as they increase domestic demand in the short term as businesses and consumers move away from foreign suppliers. |
| The relatively benign September CPI inflation report suggests the tariff shock on consumer inflation may be less than initially feared, but may end up being more drawn out. Recent research from the St. Louis Federal Reserve found that the tariffs introduced at the start of 2025 contributed around 0.5 percentage points to headline PCE inflation in the June-to-August period, and about 0.4 percentage points to core PCE inflation. Measured over the 12 months ending August 2025, tariffs are estimated to explain a small share (roughly 11%) of headline PCE inflation. The Yale Budget lab reported that core goods and durable goods prices were running 1.9% and 2.3%, respectively, above their pre-2025 trend in June with outsized price increases seen in tariff-sensitive categories like electronics, appliances, and furniture. So, tariff-driven price effects have been surfacing, but the pass-through appears to be less or happening slower than many had expected. The St. Louis Fed paper noted that the pass-through to prices so far is partial: only about 35% of the model-predicted effect had materialized by August. Some private-sector estimates are that U.S. firms are currently passing through about half of the tariffs and could possibly rise to around 70% by the end of the year. We suspect in many cases importers and firms are deferring some of the cost increases, choosing to absorb them at least initially, meaning the full inflationary effect from the tariffs will likely show up with a lag and be spread out over a longer period of time. In contrast, research from the San Francisco Federal Reserve suggested the increase in PCE inflation in June, July and August was largely driven by increasing demand and not a negative supply shock (Chart 1). Surprisingly, the supply-driven shocks appear to have been much larger in the first five months of 2025. In addition, the supply-driven contributions to year-on-year headline PCE inflation since the beginning of the year have been relatively small and largely flat, averaging around 0.84 ppts, according to the model. In contrast, the demand-driven inflation contributions have been steadily rising, contributing around 1.6 ppts to headline PCE inflation in August (up from around 1.2 ppts back in January; Chart 2). The final chapter on the tariff impact on inflation has yet to be written and the debate among economists will rage on. The takeaway of this latest tariff research and the CPI report for the Federal Reserve, in my opinion, is that inflation at the end of the year won’t likely be as bad as initially modeled given the delayed tariff pass-though, clearing the way for a couple more rate cuts this year. However, the FOMC shouldn’t completely dismiss the risks in 2026 either, as inflation could remain firmly above their 2% target. We are forecasting core PCE inflation of 2.9% y/y in 2025Q4 (Chart 3), raising the risk that if aggregate demand heats up more than expected next year, inflation could again emerge as public enemy #1. |
Fed Policy Preview: Rate Cuts Continue |
| The FOMC is expected to reduce policy rates by 25 bps on October 29, lowering the target range for the fed funds rate to 3.75%-to-4.00%. This will mark the second consecutive action after remaining on hold through the first eight months of the year. The long pause reflected increased Fed uncertainty about the inflation outlook owing to tariffs. From a risk management perspective, a pause made sense as long as the labor market remained sturdy, which it did until leading up to last month’s confab. With the Fed restarting rate cuts, the market has been busy bouncing around the odds of follow-up moves at October-end, or mid-December, or both (our call), with the data flow being a key determinant of the ultimate rate cut cadence. Unfortunately, the government shutdown has stopped the flow of official data as of October 1. In consequence, the Fed has been relying on anecdotal information and other data releases. Chair Powell has acknowledged that these surrogate data paint a better picture of the labor market than they do of inflation. Fortunately, the Administration recalled some furloughed BLS workers to finalize the CPI data for September to produce the cost-of-living adjustment for social security payments by November 1. The Fed will have on hand the two critical inflation reports it would’ve had if there was no shutdown (September CPI, August PCEPI). Looking at the fresher of the two, the CPI showed stubborn, if not mounting, inflation pressures. The yearly changes for the total and core indices were both 3.0% y/y with the three-month changes also the same at 3.6% annualized. Core goods prices, which should better highlight any tariff pressures, were up 1.5% y/y and 2.9% annualized over the latest three months. Both are the fastest since the spring of 2023, when the surge due to the pandemic and supply chain disruptions was unwinding. Meanwhile, the alternative labor market data are pointing to weakness persisting, if not worsening, in September. The Fed’s Beige Book said: “In most Districts, more employers reported lowering head counts through layoffs and attrition”. Elsewhere, ADP’s report showed private payrolls dropping by 32k, the third negative print in the past four months. The Conference Board’s net ‘jobs hard to get’ metric posted its second-largest jump in the past 17 months (this metric correlates well with the jobless rate). The two ISM surveys’ employment components remained below 50. We figure the decision to cut rates by 25 bps will not be unanimous. Newest governor Stephen Miran will likely dissent (as he did last month) in favor of a larger reduction. And, given the latest evidence of sticky inflation amid reports of more businesses planning to raise prices because of tariffs (as the limits of margin compression and drawing down pre-tariff inventories are being reached), one cannot rule out a dissent in favor of keeping rates unchanged. While the labor market is weakening, the broader economy is still doing okay thanks to accommodative financial conditions (a hefty wealth effect) and sturdy business investment (tied to AI). Recall (from the ‘dot plot’) that the FOMC’s conviction about another 50-bps worth of easing this year was not that strong to begin with. There were 10 participants in the two-or-more rate cuts camp and nine in the one-or-none group. In any event, we expect the Fed’s rate cut cadence to slow past the turn of the year (to once per quarter) with policy rates already 75 bps lower and as other tax cuts related to the One Big Beautiful Bill Act kick in. |
