Tariffs, the Phillips Curve, and the Fed’s Cruel Dilemma

In 1973, matriculating from Princeton, I submitted to William Branson my senior thesis entitled “The Nature of the Phillips Curve” in which I examined the trade-off between inflation and unemployment. I’ve been fascinated with the curve ever since.

Thought on the curve has advanced over the years. Milton Friedman’s “natural rate” hypothesis became widely accepted, implying no long-run trade-off exists. Empirical representations of “sticky” prices and inflation expectations, once combined in lagged inflation rates, are now separated into a backward-looking component for sticky prices and a forward-looking component for (usually survey-based) long-term expectations. Successful monetary policy anchored inflation expectations near the Fed’s now-explicit 2% target, and with that success the slope of the curve flattened. Supply shocks, which temporarily worsen the short-run trade-off, have been added to the curve for food and energy prices, the exchange rate and, most recently, COVID-related disruptions to supply chains. But decades later, the dilemma for monetary policy presented by the Phillips Curve remains unchanged: in the short run, with expectations anchored, the Fed chooses between higher inflation or lower unemployment. The risk of choosing lower unemployment is expectations becoming unmoored, pushing inflation persistently above 2%. The risk of choosing lower inflation is recession.

Today there is a new supply shock to consider: tariffs. Approximately 10% of “core” (excluding food and energy) personal consumption expenditures (PCE) are imports: 6% directly as final consumer goods, 4% indirectly as inputs to the production of final consumer goods and services. Hence, the 10% universal tariff threatened for July by the Trump Administration, if “passed through” entirely and immediately to consumers, would add approximately 4 percentage points to the annualized rate of core PCE inflation in the third quarter of this year. My own work suggests pass-through is delayed and incomplete, with about 75% of the tariff appearing in consumer prices within one year, and 88% within two years. Still, this would be a significant inflation shock. In could be squashed by tight monetary policy, but at what cost?

Using a “modern” Phillips Curve for core PCE inflation described in 2016 by (then) Fed Chair Janet Yellen at the annual meeting of National Association for Business Economics, I explored the horns of the Fed’s current dilemma. First, I generated a baseline forecast assuming no tariffs, unemployment at 4%, and expectations at 2% (Chart 1). After 2025, baseline inflation (4-quarter percent change) fades fairly quickly to the Fed’s target. Then, I introduced a 10% tariff shock while assuming the Fed maintains unemployment at 4%, again with expectations at 2%. When the tariff is thusly “accommodated” by monetary policy, inflation remains above 3% through 2026, and above 2.5% through 2027 – high enough and for long enough to make any central banker uncomfortable. Would expectations remain anchored at 2%? Perhaps, even probably, so: they did during the much bigger COVID-era price shock.

Next, I reversed the process, using the trade-off between inflation and unemployment embodied in the Phillips Curve to compute how high the unemployment rate would have to rise to maintain inflation along the baseline path, again with expectations at 2% (Chart 2). To curve neophytes the result might seem shocking: it would take an unemployment rate (4-quarter moving average) exceeding 12%! Why? Because here the Fed is a victim of its own success. The gradual flattening of the slope of the Phillips Curve implies that today demand shocks have a limited impact on inflation. The corollary, however, is that to offset supply shocks today requires very large swings in unemployment. In my experiment, in the extremes, through 2028 the Fed can choose between 2 point-years of higher inflation, or 5 point-years of higher unemployment – a distinctly unsavory choice.

No doubt the actual outcome would fall between these extremes. Furthermore, it could be affected by shifts in the coefficients in the Phillips Curve in response to the tariffs. And expectations could break from 2%, especially to the downside if unemployment climbs rapidly. The terms of the trade-off seemingly favor partial accommodation of the inflation shock. But the Fed faces a dilemma, and it is cruel.

A PDF version of this commentary is available here.