Four Ways Tariffs Raise Inflation By Investing.com

Investing.com — Economists have been cautiously optimistic in recent months, celebrating the containment of inflation after a turbulent period. However, the prospect of tariffs threatens to undermine this progress, potentially reigniting inflationary pressures.

While tariffs are often seen as one-off price increases akin to specialized sales taxes, their influence on inflation is much more complex and widespread.

Analysts at UBS warn that the impact of the tariffs extends beyond the immediate rise in consumer prices, creating ripple effects that can exacerbate inflation through multiple channels.

Essentially, tariffs function as taxes on imported goods, with the cost usually passed on to consumers. This leads to an initial rise in prices, which might appear to be a temporary change in the price level, rather than the kind of sustained inflation that economists fear.

However, the actual inflationary impact of tariffs is not so simple. A deeper look reveals how tariffs can fuel profit-driven inflation, raise wages, reduce market competition, and destabilize supply chains—all contributing to a long-term inflationary cycle.

One of the effects of tariffs is their ability to facilitate profit-driven inflation. When a tariff is introduced, consumers often expect a proportional increase in prices, believing that a 10% tariff should result in a corresponding 10% increase in the cost of goods.

However, the tariffs are levied on the import price rather than the final consumer price, meaning the actual impact on retail prices should be much smaller.

For example, a 10% tariff applied to the import price – often much less than half the consumer price – should translate into an increase of less than 5% at the retail level. In reality, businesses frequently use the imposition of tariffs as an opportunity to raise prices beyond what is justified by rising costs, padding their profit margins.

UBS analysts point out that this mechanism allows companies to hide their motives behind the history of tariffs, leading to inflation that is driven not by higher costs, but by inflated profits.

This price increase, either directly from tariffs or opportunistically inflated by companies, often has a second-order effect on the labor market, triggering demands for higher wages.

Workers, seeing their purchasing power eroded by higher prices of tariff-affected goods, are likely to push for wage increases to offset the rising cost of living.

When tariffs are broad, affecting a wide range of products and sectors, these wage demands can become widespread, affecting both trade and non-trade sectors of the economy.

As businesses respond to higher labor costs by further raising prices, the economy risks entering a wage-price spiral, in which rising wages and rising prices continually feed off each other. UBS notes that this dynamic can become deeply entrenched, making it more difficult to dampen inflation once the cycle has begun.

Beyond the immediate impact on prices and wages, tariffs also have a more insidious effect on market competition, which in turn fuels inflation. By imposing barriers to imported goods, tariffs reduce competitive pressures that normally help keep prices under control.

When foreign companies face punitive tariffs, they may be dissuaded from entering or maintaining a presence in a market where they face an injurious sales tax.

Even after tariffs are lifted, the damage to competition may be lasting, as companies are reluctant to reinvest in markets where they once faced protectionist measures.

This reduced competition gives domestic companies more freedom to raise prices without fear of being undercut by cheaper foreign alternatives. UBS analysts say this long-term reduction in competition may create a more inflationary environment as firms enjoy greater pricing power in the absence of external pressures to keep costs low.

In addition to these demand-side factors, tariffs also exert inflationary pressure on the supply side, disrupting global supply chains. Modern economies rely on deeply integrated supply networks, with raw materials and components crossing multiple borders before being assembled into finished products. When tariffs increase the cost of imports, they increase input costs for producers, which are then passed on to consumers.

This effect can be particularly pronounced in industries where the supply chain is complex and global, such as electronics and automobiles.

According to UBS analysts, supply-side inflation caused by tariffs can be particularly damaging because it not only raises prices for individual products, but also disrupts the efficient flow of goods across borders, leading to new bottlenecks and cost increases across the economy .

Taken together, these dynamics illustrate how tariffs can do much more than create a one-time increase in prices. They interact with broader economic forces, amplifying inflationary pressures in ways that are both direct and indirect.

By allowing profit-driven price increases, boosting wage demands, stifling competition, and disrupting supply chains, tariffs contribute to sustained price increases that go beyond their immediate effect. As policymakers weigh the potential benefits of protectionist measures against the risk of inflation, they must be mindful of these complex interactions.

UBS analysts stress the importance of considering these inflationary risks, particularly in a global economy still recovering from recent inflation crises. While tariffs may serve as a tool to protect domestic industries or increase government revenue, their broader economic impact may reignite inflation just as it appears to be stabilizing.

For governments and central banks, managing these risks will be critical to maintaining economic stability and avoiding a return to the high-inflation environment that many are eager to leave behind.