Investors this week will be focused on the implications of the U.S. attack on Iranian nuclear facilities. While this is clearly a very significant event from a geopolitical perspective, it may be less important for financial markets.
The key issue is how Iran responds. One often-mentioned scenario is that they could try to close the Strait of Hormuz. Such a move would have a dramatic impact on world energy markets as roughly 20% of the world’s oil production moves through the Strait. However, this strategy would be highly counterproductive for Iran, first, because it would eliminate its own ability to export oil and second because it would trigger a U.S. effort to reopen the Strait that could further damage Iran’s depleted military capabilities.
An energy shock could also be caused by an Iranian attack on the oil and gas infrastructure of other nations in the region. Again, however, this would likely trigger a retaliatory attack on Iranian energy production, refining and distribution which Iran would presumably want to avoid.
A third possibility is that Israel or the United States bombs Iranian energy infrastructure in retaliation for an Iranian attack on U.S. or Israeli military targets or civilian facilities. However, the U.S. would be very reluctant to take actions that would boost global oil prices and likely would discourage Israel from doing so either.
History will eventually judge the wisdom of the Israeli and U.S. actions of the last two weeks. While these actions have clearly inflicted a great deal of damage on Iran’s military, in general, and its nuclear program, in particular, it is not clear that this represents the end of Iran’s nuclear ambitions or capabilities. Moreover, as has happened many times in the past, turmoil in the Middle-East can lead to dramatic terrorist attacks in the region or around the world. However, for now, while the situation is clearly very serious and unpredictable, investors may still want to also pay attention to other issues that could shape financial markets in the months and years ahead. One of these is tariffs and their inflation impact.
Nothing deceives the human brain more predictably than a delayed reaction. The child who maintains a brave silence immediately after falling on the sidewalk. The marathon runner who, feeling energized at mile 14, has ignored his coach’s advice not to go out too fast. The sunbathers watching in amusement as the suit-and-tied weatherman predicts the storm to come. It is only after the child screams, the runner hits the wall and the rain buckets down on the scantily-clad multitude scurrying for shelter that reality hits home. So it will be with tariffs and inflation.
There is little evidence, so far, of tariff impacts on consumer inflation. The CPI rose just 0.1% in May, with the year-over-year increase edging up only slightly, from 2.3% to 2.4%. This week’s PCE deflator release should look equally benign, with an expected 0.1% month-over-month increase lifting the year-over-year gain to 2.2% in May from just 2.1% in April.
Nevertheless, we, like the Federal Reserve, expect tariffs to boost inflation in the months ahead, pushing year-over-year consumption deflator inflation to 3% or above by the fourth quarter. However, there remains plenty of uncertainty around the extent, timing and persistence of tariff inflation and it is worth considering all of these when developing an investment strategy.
The Inevitability of Tariff Inflation
A prediction of tariff inflation starts, simply, with tariff revenues. We estimate that, as of today, the average tariff rate imposed by the United States on imported goods is 14.6%, consisting of a universal tariff of 10% on most countries, higher tariffs on China and on steel, aluminum, autos and auto parts and lower tariffs on Canadian and Mexican goods covered by the USMCA. This number could rise if the U.S. does not come to trade agreements with trading partners by the end of a 90-day pause window, which occurs on July 9th.
However, assuming that average tariff rates don’t change on July 9th and that U.S. imports by good and country are the same in 2025 as in 2024, then a 14.6% rate, applied to 2024 goods imports of $3.295 trillion, would have yielded an annualized $481 billion in tariff revenue. This compares to $86 billion actually collected in 2024. As we will discuss, there is a lag between the announcement of tariffs and their implementation and a further lag between when importers pay them and consumers are impacted by them. Still, it is reasonable to assume that the full impact of this 14.6% tariff rate would be felt by, and divided among, foreign businesses, U.S. importers and U.S. consumers, by the fourth quarter of this year.
But how will this cost be divided? If the increase in tariffs were fully borne by consumers and if they didn’t change their spending habits (two big “ifs”), then they would have to pay an extra $395 billion annualized in import taxes, (that is to say, $481 billion minus $86 billion), in the fourth quarter of 2025. Nominal consumer spending on goods and services in the fourth quarter of 2024 was $20.408 trillion so $395 billion in import taxes would raise the prices of those goods and services, otherwise known as the PCE deflator, by 1.94%.
Of course, this includes two big assumptions that need to be softened.
First, consumers may reduce their real purchases of tariffed items, either by simply consuming less, switching from the products of more highly-tariffed nations, such as China, to countries upon whom we have imposed lower tariffs, such as Mexico, or buying American. That being said, the universal nature of the tariffs and the inability of the U.S. to quickly stand up low-cost manufacturing suggests that the scope for switching among countries of origin could be limited.
Second, foreign suppliers might try to eat some of the cost of the tariffs themselves. How much they would be able to do so would depend on the profitability of their exports in the first place. While some industries, such as pharmaceuticals, have relatively high profit margins that could be vulnerable, much of what the U.S. imports is produced at highly competitive prices with U.S. buyers already putting significant pressure on their foreign suppliers. In addition, for many consumer goods, wholesale and retail margins in the U.S. are very tight, limiting the ability of wholesalers and retailers to absorb the cost.
A Federal Reserve paper, released in May, suggested that the tariffs could feed through 100% to consumer prices1. However, even if we make the more conservative assumption that 60% of the cost is paid by consumers, with 20% being absorbed by foreign producers and 20% being borne by domestic wholesalers and retailers, a sustained 14.6% tariff rate could lead to a one-time boost in the PCE deflator of 1.16%.
Inflation Offsets
Since the year-over-year increase in the PCE deflator in the fourth quarter of 2024 was 2.5%, this would suggest, all other things being equal, a 4.0% year-over-year inflation rate by the fourth quarter of this year. But all other things are not equal.
First, two key areas of sticky services inflation have eased over the past year. Actual rent and owners’ equivalent rent, which together account for more than a third of CPI, were up 3.8% and 4.2% year-over-year respectively in May 2025 compared to 5.3% and 5.7% in May 2024. Auto insurance, which was up 20.3% year-over-year in May 2024 rose by a still substantial, but much lower, 7.0% over the past year. Second, a slump in U.S. tourism has led to a 7.3% year-over-year decline in airline fares and a 1.7% fall in hotel rates over the past year.
This being said, even without tariffs, recent good news on U.S. inflation may be coming to an end. Energy prices were down 3.5% year-over-year in May, partly reflecting a softer global economy but recent events in the Middle East are likely to reverse this trend. The trade-weighted U.S. dollar index has fallen roughly 6%, year-to-date, which should add something to import prices. Moreover, year-over-year wage growth, which fell from 5.9% in March of 2022 to just 4.1% by December 2023, has since settled into a narrow range of 3.9% to 4.3%.
All of this suggest that, barring a serious recession, inflation will rise notably in the second half of 2025, with the increase being largely due to tariffs.
Delayed Impact
But if tariffs are going to lead to higher inflation, why hasn’t this shown up yet?
Part of the issue is simply that the majority of the tariff increases have been quite recent. While the President has announced many increases in tariffs on different countries and different commodities since February, and subsequently paused or lowered many of them, the most substantial increases have only been in effect since the second week in April. Moreover, good that had already been shipped from a foreign port when these increases were announced, were exempt, meaning that most of the tariffs would not have been collected at U.S. ports until May. This can be seen in monthly tariff revenue which equaled 5.9% of the value of imported goods in April, up from 2.6% a year earlier, but far lower than the actual effective tariff rate on new imports that was well into the double digits for the month.
Moreover, as noted by Jay Powell in his press conference last week, even if importers paid the higher duties, these costs may not be passed on to consumers until retailers actually sell the new inventories upon which the tariffs had been paid. Consequently, the impact of higher tariffs on consumer goods prices will likely be phased in over the summer rather than showing up in CPI data for April, May or even June.
Could Tariff Inflation Linger?
The administration is clearly under significant pressure to end the tariff uncertainty and we expect that, with decisions made over the next month, tariff rates will largely settle in at levels that could be maintained for years to come. The administration will have every incentive to convince markets that tariffs are permanent. Any doubt on this issue could reduce tariff revenue itself, by incentivizing importers to delay purchases, and would also undercut any incentive to try to source products domestically. Moreover, future administrations, whether Republican or Democrat, will find it hard to repeal the tariffs, once in place, due to the substantial revenue stream that they will likely generate.
However, lingering tariffs does not mean lingering tariff inflation. Once the impact of higher tariff levels is fully reflected in the CPI and PCE indices, they will cease to have an impact on inflation. Higher inflation could, of course, be extended by fiscal stimulus from the reconciliation bill making its way through Congress. However, we expect that most of this stimulus will kick in in late 2025 and early 2026 and, by the end of 2026, PCE inflation will finally slide back to the Fed’s 2.0% target.
Investment Implications
For investors, it is important to take a balanced view. Higher tariffs will slow the economy and raise inflation in the short-run. However, while some of the drag on economic growth from higher tariffs should linger, their impact on inflation should fade. Because of this, while tariffs and the potential for fiscal stimulus may mean very little Fed easing in 2025 and early 2026, by later next year, the Fed could begin to cut rates more aggressively. This, in combination with a relatively slow-growing economy, could finally allow for some long-awaited reduction in long-term interest rates, which would be a positive for both U.S. bond and stock markets even if it provided little help to the U.S. economy itself.