The Big Idea
Tariffs and inflation expectations
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Speculation regarding tariffs has dominated the conversation on the inflation outlook so far in 2025. It is commonly understood that tariff hikes should have a mostly short-term impact on prices, but recent survey data suggest that longer-term inflation expectations may also be inching higher.
Tariffs and inflation
The broad-brush prevailing argument has been that tariffs are inflationary. However, this is not quite accurate. Inflation is the rate of change in prices. The Fed cares mostly about the medium-term and long-term underlying trend in inflation. Tariffs are, at least on paper, a one-time change in the level of prices, not a persistent shift in the inflation rate.
To walk through the arithmetic, just to make the math easy, let’s say that the US imposes a 10% across-the-board tariff on all goods imports. Merchandise imports amount to almost $3.3 trillion, which is about 11% of GDP. So, in theory, the imposition of tariffs would raise the price level by 1.1% (an 11% weight times 10%). The inflation rate would go up sharply in the first month after applying the tariffs, and then, abstracting from possible second- and third-round effects, the monthly inflation figures would move back to normal the very next month. Year-over-year figures would, of course, remain inflated for 12 months, after which the inflation rate should return more or less to its prior path.
The reality is a bit more complicated. The initial imposition of tariffs could spark retaliation, which might ultimately lead to multiple rounds of tariff hikes. Firms might not all pass through the higher costs immediately (or entirely). And teasing out the exact impact of tariffs on inflation could be difficult given that so many line items within the inflation measures would potentially be affected.
Nevertheless, the larger point holds. Tariffs should have only a temporary impact on inflation. If the FOMC is able to do so, it would presumably filter out the impact of tariffs on prices and set policy rates according to its understanding of the underlying inflation trend. The most we could say is that the Fed might be extra cautious during the period when tariffs were pushing prices up given a lack of clarity on the underlying inflation trend. The bottom line is that tariffs should have a fleeting impact on inflation and, in turn, on Fed policy.
TIPS Breakevens
One way of gauging inflation expectations is to examine TIPS breakevens, which offer a view of how much financial market participants believe that they need to be compensated for inflation to be made whole on their nominal Treasury holdings. The evolution of TIPS breakevens appear to conform tightly to the narrative above.
In the short run, inflation is expected to jump. Investors have been steadily raising their expectations for the 1-year breakeven inflation rate over the next year since just before the election, with a one-year breakeven rate of nearly 4% priced in as of Thursday (Exhibit 1).
Exhibit 1: 1-Year TIPS Breakeven Rate
Source: Bloomberg.
At the same time, longer-term inflation expectations have barely moved. The 5-year 5-year forward breakeven is the predicted rate of inflation for the five years starting five years from now—in the current instance, average inflation from February 2030 through February 2035 (Exhibit 2). This is a popular gauge, as a number of Fed officials over the years have highlighted this calculation as a decent proxy for longer-run inflation expectations.
Exhibit 2: 5-Year, 5-Year Forward TIPS Breakeven Rate
Source: Bloomberg.
The 5-year 5-year forward breakeven rate has moved around a little but in a mostly trendless fashion. In fact, the measure closed on Election Day at 2.278% and traded as of Thursday at 2.272%. Thus, investors are indicating that tariffs (or the new administration’s policies more broadly) will have no lasting impact on inflation.
Consumer surveys
However, consumer surveys are offering a somewhat different view regarding longer-run inflation expectations. As expected, respondents to the University of Michigan consumer survey have raised their inflation expectations for the next year sharply in recent months (Exhibit 3). In fact, the median response has surged from 2.6% in November to 4.3% in early February, the highest level in over 30 years with the exception of the pandemic years and three brief periods when oil prices spiked (2005, 2008, and 2011).
Exhibit 3: University of Michigan survey 1-year inflation expectations
Source: University of Michigan Survey of Consumers.
However, the same survey has found that 5- to 10-year inflation expectations have also risen since the election (Exhibit 4). The early-February reading of 3.3% is the highest since 2008 and up from the prevailing pre-election trend of 3.0%.
Exhibit 4: University of Michigan survey 5-to-10-year inflation expectations
Source: University of Michigan Survey of Consumers.
A separate survey of consumers conducted by the New York Fed also asks about inflation expectations. This survey has a much shorter history and is not as well-known as the University of Michigan effort, but it offers an alternative view on households’ thinking with regards to inflation.
Interestingly, the recent results are almost the opposite of what the economic narrative would suggest. The median one-year inflation expectation has been steady at 3.0% since the election. In contrast, the median 3-year and 5-year expectations have crept slightly higher. The 3-year gauge has inched up from 2.6% in November to 3.0% in January (Exhibit 5). While this is certainly no cause for alarm, any further rise would put the measure in territory not seen since the pandemic.
Exhibit 5: NY Fed 3-year inflation expectations
Source: NY Fed.
Similarly, at the five-year time horizon, the New York Fed survey found that consumers’ median inflation expectations inched up from a prevailing level of 2.8% before the election to 3.0% in January. This matches the highest reading in over two years, though this gauge only goes back three years, so the history is limited.
Conclusion
While the numbers have not moved up by enough just yet to offer cause for alarm, it is intriguing that households’ longer-term inflation expectations have crept higher in recent months. While it is understandable that the talk of tariffs would push up inflation expectations for the near term, the longer-run outlook should not be impacted. It is unclear at this point whether households misunderstand the influence of tariffs on inflation or have some other reason to worry about an acceleration of price hikes in the longer term. In either case, rising household inflation expectations are a worrisome sign at a time when the Fed is trying to bring inflation back down to its 2% target.
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