Tariffs May Not Move The Inflation Needle By Much

If you watch television news, you could be led to believe that tariffs are the worst thing to hit the domestic economy since the 1930s. But if you look at the five-year breakeven rate (below), the only conclusion is that very little has changed on the inflation front. Employment, GDP and other economic indicators also suggest it is more or less business as usual for the economy.

The Open Market Committee, of course, remains somewhat divided on the matter, as evidenced by a relatively wide dot-plot spread for 2026 and 2027. Chairman Powell is in the "wait-and-see" camp, explaining that if tariffs do turn out to be inflationary, as many expect, we’ll see evidence of that sometime this summer. If tariffs instead tilt toward demand destruction, then we won’t.

But the bond market’s view is compelling: there may only be a small inflationary impact from tariffs, leaving other factors (productivity, oil prices, wage growth) to determine the overall outcome. Tellingly, the five-year breakeven rate has more closely tracked oil prices than tariff concerns. This makes sense, given that the average household will spend perhaps 5-10 times more on gasoline than tariff-related price increases in 2025. The bond market also knows that in a service-oriented economy (where goods and agriculture account for less than 25% of GDP), tariffs on "stuff" don’t have much effect.

The other thing that blunts the impact of tariffs is the First Sale Rule. It allows tariffs to be applied to the lowest cost of a given item in its country of origin. So, for example, a 50% tariff on a plastic auto part sourced from China might amount to 50 cents. When an auto dealer turns around and sells that same part to a U.S. consumer for $30, the tariff is fairly easy to absorb. Even when passed along, the consumer might only see a 5% increase.

Odds are there will be three main outcomes from tariffs, none of which are strongly inflationary. There’s the above case, where the market can bear thetariff but it doesn’t amount to much at the retail level. The second outcome is that the item in question is obtained from a different country where the tariff burden is lighter. Finally, in the case of higher-value items where the tariff cannot easily be absorbed or passed along (such as autos), manufacturing is moved to the U.S.

There will, of course, be some cases where the consumer bears the full brunt of tariffs on items that are not low cost, such as luxury goods. But these cases don’t usually figure prominently in the inflation indexes. It’s also an area where tariffs and luxury taxes have long been in place.

Finally, it’s worth noting that there are bigger, more important things going on than tariffs. AI is reshaping the economy, making it more productive while boosting corporate earnings. And federal deficits are now looking to remain above 6% of GDP for the foreseeable future, making it unlikely that the economy could see a recession (growing federal debt, of course, is a topic for future discussion).

Second Quarter Review
While tariff-related investor anxiety was running high at the beginning of the quarter, by the end of June it was clear that any impact on the economy would likely be muted: data on GDP, employment, earnings and inflation all suggested that it is more or less business as usual for the economy. The S&P 500 made a full recovery to its February high, posting a gain of 10.9% for the quarter, which brought its year-to-date gain to 6.2%.

The bond market was also a welcome surprise, with interest rates declining slightly over the three-month period. From an inflation standpoint, the oil price decline that accompanied the imposition of tariffs seemed to matter more than the resulting higher prices on imports. The U.S. Aggregate Bond Index gained 1.2% for the three-month period, finishing with a 4.0% year-todate increase.

Our model portfolios outperformed. On the stock side, our continuing bias toward growth stocks helped. And on the bond side, our emphasis on short-intermediate maturities benefitted from a shift in the yield curve as the bond market anticipated additional easing moves from the Fed in the second half.

Looking Ahead
Trade agreements are likely to take shape in the third quarter, with long-term tariff rates of 10- 50% depending on the specifics of each agreement. If there is going to be a pronounced impact on inflation, we’ll likely see it reflected during the summer months. But if oil prices remain below last year’s levels, odds are the impact will be modest.

That could free the Fed to restart its easing cycle. Currently, the market is expecting 2-3 quarterpoint rate cuts during the balance of the year. Beyond that, the Fed’s latest dot-plot suggests we might see 2-3 more reductions in 2026-2027 (assuming inflation continues to track toward 2%).

Money market yields, of course, would fall in tandem with any easing moves. The U.S. dollar is still about 20% higher than its average from 2008-2014 (following that period, the shale-oil industry scaled up, making the U.S. a net energy exporter). But the recent decline should provide a slight boost during the upcoming earnings season, as a weaker dollar means that foreign earnings are worth more in dollar terms (as a group, the S&P 500 books some 40% of its revenue abroad).

There are growing signs that AI technology may have a positive impact on the earnings of smaller companies. If so, there may be hope for the Russell 2000 and other small-to-mid-cap benchmarks, which have long lagged the S&P 500. We’ll be watching this trend, with an eye toward boosting our weighting in smaller stocks beyond the mid-cap growth exposure that we already have.

Fidelity Monitor & Insight To Cease Publication January 2027
For those of you who receive a free copy of our affiliate’s newsletter, Fidelity Monitor & Insight, I am sad to say that we will be winding things down over the next 16 months, as the newsletter’s circulation is down to a small fraction of what it once was. Bowers Wealth Management has continued to grow, even as the newsletter shrinks, so it’s becoming increasingly necessary for me to spend more time on the advisory side.

Sincerely,

Jack Bowers
President & Chief Investment Officer