Why has U.S. inflation consistently fallen short of expectations after the tariffs were implemented?

Core Viewpoints

Core Viewpoint: Since the implementation of Trump's tariffs in February, U.S. core inflation has unexpectedly fallen short of expectations for five consecutive months. We believe the reasons for this outcome include: U.S. traders' imports and inventory cycles being advanced, an increase in the scale of imports from Mexico that continues to input deflation into the U.S., the relatively small weight of tariff-sensitive core goods in the CPI, and the negative impact of tariffs on the service sector and overall U.S. economic demand. Looking ahead, we tend to believe that the U.S. CPI's month-on-month growth center is more likely to fall short of market expectations in the coming quarter, but the uncertainty of tariffs' impact on inflation, the uncertainty of the tariffs themselves, and Powell's appeal for the independence of monetary policy mean that the current market expectation of two rate cuts by the Federal Reserve in 25H2 is difficult to achieve, and there remains a risk of rate cuts falling short of expectations.

Horizontally, how much of the tariff pressure has been transmitted to core goods? The cost brought about by tariffs is shared among four links in the trade chain, corresponding to foreign manufacturers (foreign PPI), foreign traders (exchange rates), domestic traders (domestic PPI), and domestic consumers (domestic CPI). During the 2018-19 period, under the hedging of the other links mentioned above, only 0.2% of the price pressure was transmitted to the U.S. CPI.

However, unlike the previous round of trade friction, the biggest buffer zone for this round of U.S. tariffs should be U.S. traders. This round of U.S. traders has hedged the impact of high tariffs on commodity inflation so far by: ① advancing commodity imports; ② increasing duty-free goods from Mexico under USCMA and low-priced goods from Vietnam. Additionally, from the June CPI data, the month-on-month growth rate of prices for tariff-sensitive items such as home furnishings & supplies, clothing, and leisure goods has accelerated, but due to their small proportion in core goods, their contribution to overall and core CPI is not high.

Vertically, what is the comprehensive impact of tariffs on U.S. inflation? Since tariffs are essentially contractionary policies, under unchanged overall economic demand, tariffs cause stagflation in the goods sector and recessionary shocks in the service sector. Therefore, while tariffs bring inflationary pressure to U.S. core goods, the U.S. core CPI is actually showing a downward trend under the drag of core services. The Federal Reserve's breakdown of inflation shows that since February of this year, the rise in PCE inflation has mainly come from supply factors, while the contribution from demand factors has significantly weakened.**

Looking ahead, how should we understand and trade the future impact of U.S. inflation? After the June CPI was released, as the upward pressure of tariffs on commodity inflation began to manifest, traders expected that the U.S. CPI would continue to operate at a month-on-month growth center of 0.3% in the coming quarter. However, considering the above factors, we tend to believe that the U.S. CPI's month-on-month growth center is more likely to fall short of market expectations in the coming quarter, and the year-on-year growth rate of U.S. CPI in 25Q3 is still expected to remain below 3%.

But this does not mean that the Federal Reserve will implement larger rate cuts in the second half of the year. First, it is still not possible to verify whether the impact of tariffs on U.S. growth and inflation is a one-time lagging effect or a persistent one, which is also the main reason the Federal Reserve is caught in a dilemma regarding rate cut decisions Secondly, there remains a high degree of uncertainty regarding tariffs, and even if U.S. inflation does not significantly rise in Q3, it will be difficult for the Federal Reserve to determine whether new tariff conflicts will pose upward risks to inflation in the future. Finally, Trump's continued interference with the independence of the Federal Reserve may lead Powell to choose to delay interest rate cuts, considering the need to maintain monetary policy independence, especially when growth and inflation are not under significant pressure.

Main Text Below

Since February this year, Trump has begun to impose tariffs on his trading partners, and on April 2, he raised tariffs globally by at least 10%. Interestingly, since February, the month-on-month growth rate of the U.S. core CPI has consistently fallen short of analysts' expectations. On one hand, tariffs are rising, while on the other hand, inflation continues to underperform expectations. This strange combination has led to a decline in the Bloomberg U.S. inflation surprise index since the release of the February U.S. CPI in March.

Why has U.S. inflation continued to fall short of expectations after the implementation of tariffs? We analyze this issue from two perspectives: ① Horizontally, how much of the price pressure from tariffs has been transmitted to U.S. core goods inflation? ② Vertically, while tariffs contribute to inflation in core goods, what is their impact on core services and U.S. inflation?

1. Horizontally, how much of the tariff pressure has been transmitted to core goods?

Theoretically, the costs imposed by tariffs should be shared across the entire trade chain, which consists of four links: foreign production, foreign trade, domestic trade, and domestic consumption, corresponding to foreign manufacturers, foreign traders, domestic traders, and domestic consumers. Taking U.S.-China trade as an example, the simple logical relationship of trade chain profit margins is as follows:

Trade chain profit margin = U.S. goods CPI – U.S. trade PPI – exchange rate – China PPI

For instance, during the last round of trade friction, from April 2018 to September 2019, the average effective tariff rate imposed by the U.S. on China increased from 5.87% to 13.61%, reaching 19.48%, while during the same period, China's PPI growth rate fell by 4.6% to -1.2%, and the RMB depreciated against the USD by 13.1% to 7.12. It can be said that the foreign production and foreign trade links alone have offset all the tariff impacts. During the same period, the year-on-year growth rate of U.S. wholesale trade PPI rose from 2.24% to 4.23%, and retail trade PPI increased from 3.27% to 4.14%, while core goods CPI only rose from 1.03% to 0.66%. Given that core goods account for only 20% of the CPI, only 0.2% of the price pressure from the last round of trade friction was transmitted to the U.S. CPI. Additionally, due to falling oil prices, the year-on-year increase in CPI during this period actually decreased by 0.75% to 1.71%

However, times have changed. According to TBL's calculations, the average effective tariff rate in the United States has risen from 2.4% to 28% as of 2025, with the latest figure at 19.7%. Meanwhile, China's PPI and exchange rate trends have remained relatively stable, while the US dollar index has dropped by as much as 10%. During this period, the year-on-year growth rate of the US core CPI has increased by 0.83% to 0.7%. If we reverse engineer from this, the maximum buffer zone for the current round of US tariffs should be among American traders.

So, how is this buffer zone for tariffs constituted?

1.1. A Temporary Measure: Frontloading Imports

Due to strong expectations of tariffs in the market when Trump was elected last year, American traders began to accelerate the frontloading of imports and restocking since the end of last year. Since December 2024, the growth rate of US imports has started to soar. In Q1 2025, net exports dragged down the US GDP growth rate by -4.61%, while inventory changes boosted GDP growth by +2.59%. These imports, completed before the equivalent tariffs took effect on April 2, temporarily slowed the transmission of tariffs to the American consumer sector at the trader level.

1.2. A Trade-off: Import Substitution Effect

Although the current average effective tariff rate in the US is as high as 17.3%, if a product from Mexico or Canada meets the origin rules of the United States-Mexico-Canada Agreement (USMCA), its tariff rate is 0%. In 2024, the total scale of US imports was $3.36 trillion, with $248.7 billion and $156.5 billion of goods from Mexico and Canada, respectively, meeting USMCA standards and enjoying 0% tariff treatment, accounting for 12.3% of total imports. Water flows to lower places; under the substitution effect, the scale of US imports from Mexico has continued to rise this year. Additionally, the uncertainty of US-China trade policies has led to a significant reduction in US imports from China and a noticeable increase in imports from Vietnam this year.

The paper analyzes daily US retail data combined with HS Code/import country information and finds that this year, although the escalation of tariffs has led to a rapid increase in the prices of imported goods from China, the prices of imported goods from Mexico have been continuously declining, while the price increase for imported goods from Canada has been limited Ultimately, under the substitution effect, the United States imported more goods from Vietnam and Mexico, and the deflationary effect of imported goods from Mexico effectively buffered the pressure of tariffs on core goods inflation in the U.S. It is worth noting that although the U.S. exempted tariffs on imported products from Canada and Mexico under the USMCA framework, there are still non-USMCA products subject to tariffs, while the price index of imported goods from Mexico has been declining. In addition to seasonal factors, this may also reflect the deflationary effect of weakened domestic demand in the U.S. to some extent.

1.3. From the U.S. June CPI, how much tariff pressure has been transmitted to core goods?

The core goods CPI in June increased from a previous value of -0.04% to +0.2%. Among them, the home furnishings & supplies rose from +0.34% to +0.98%, reaching a new high since February 2022; clothing rose from -0.42% to +0.43%, and leisure goods rose from +0.41% to +0.77%. These three are the main contributors to the significant increase in core goods inflation in the U.S. in June and are sensitive to tariffs. However, since their respective weights in the CPI are 3.36%, 2.51%, and 1.82%, their overall contribution to the CPI increase is relatively small, totaling a pull of 0.05%. The transportation goods, which have the highest weight in core goods, were dragged down by the prices of new and used cars and did not show significant month-on-month increases.

Therefore, from the details of the U.S. June CPI data, it can be seen that the upward pressure on core goods inflation from tariffs has partially emerged, but due to their small proportion in core goods, their contribution to overall and core CPI is not high.

2. Looking vertically, what is the comprehensive impact of tariffs on U.S. inflation?

Since tariffs are essentially a contractionary policy, under unchanged total economic demand, tariffs cause stagflation in the goods sector and recessionary shocks in the services sector. Therefore, while tariffs bring inflationary pressure to core goods in the U.S., the core CPI in the U.S. is showing a downward trend under the drag of core services.

We can also cross-verify this through the San Francisco Fed's attribution of the year-on-year growth rate of U.S. PCE inflation. Since February of this year, the rise in PCE inflation has mainly come from supply factors, while the contribution from demand factors has significantly weakened.

Of course, the decline in core services inflation is also influenced by some other factors. Taking housing inflation as an example, since 2022, the decline in housing inflation has come from four aspects: ① High interest rates suppressing demand leading to a decline in housing prices, resulting in a lagged decline in housing inflation; ② Housing inflation is relatively sticky, so its downward trend has a large inertia; ③ The base effect from the previous period has led to a month-on-month decline in housing inflation returning to pre-pandemic central levels, but the year-on-year growth rate can still maintain a decline; ④ The recent larger month-on-month decline in rental inflation may indirectly reflect a "consumption downgrade" in the service sector.

3. Looking ahead, how to understand and trade the future impact of U.S. inflation?

After the release of the June CPI, as the upward pressure of tariffs on commodity inflation has begun to manifest, traders expect that the U.S. CPI will continue to operate at a month-on-month growth center of 0.3% in the next quarter (Figure 14). However, as analyzed in the previous two sections, due to the advance of U.S. traders' imports and inventory cycles, the increase in the scale of Mexican commodity imports leading to deflation in the U.S., the small proportion of tariff-sensitive core goods, and the negative impact of tariffs on the service sector and overall U.S. economic demand, we are more inclined to believe that the month-on-month growth center of U.S. CPI in the next quarter is more likely to fall short of market expectations, with the year-on-year growth rate of U.S. CPI in Q3 2025 still expected to remain below 3%.

However, this does not mean that the Federal Reserve will implement larger rate cuts in the second half of the year.

First, it is still impossible to verify whether the impact of tariffs on U.S. growth and inflation is a one-time lagging effect or a persistent one, which is the main reason the Federal Reserve is caught in a dilemma regarding rate cut decisions. According to current analyst consensus expectations, the year-on-year growth rate of U.S. core PCE is expected to reach 3.1% and 3.2% in Q3 and Q4 of 2025, respectively, with the unemployment rate at 4.4% and 4.5%. A marginally more stagflationary economic trend implies a lower output gap and a higher inflation gap, making it easier for the Federal Reserve's monetary policy to fall into a dilemma, ultimately leading to a wait-and-see strategy and delaying rate cuts.

Secondly, there is still a high degree of uncertainty regarding tariffs themselves. Recently, Trump has stirred up the "reciprocal tariffs" 2.0 controversy, announcing new tariff rates on certain countries and further delaying the effective date of reciprocal tariffs to August 1. Although Trump claims this is the last delay, the "TACO" characteristics of his policy and the uncertainty of tariff negotiation progress mean that the repetition of tariffs in the second half of the year remains one of the biggest policy uncertainties. For the Federal Reserve, the biggest issue it faces is that the time required to verify the transmission of tariffs to inflation is subjective and vague, and even if U.S. inflation does not significantly rise in Q3, it is still difficult for the Federal Reserve to determine whether new tariff conflicts will pose upward risks to inflation in the future.

Finally, Trump's continued interference with the independence of the Federal Reserve may lead Powell to choose to delay rate cuts in the absence of significant pressure on growth and inflation, in order to maintain the independence of monetary policy Risk Warning and Disclaimer

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