1. There are lots of conflicting effects of tariffs on UK inflation and activity. They are set out by Megan Greene in a very interesting recent speech. They can nicely be summarised in two cases.
2. Case A. Unilateral tariffs.
a. For a given exchange rate (ER).
i. US demand for UK exports falls. UK activity/inflation fall.
ii. but, offset by foreign producers who divert cheap goods to UK. Inflation falls. Raises real incomes, but bad for UK firms, so activity effect not clear.
b. But the ER might change.
i. U US $ should appreciate, so £ depreciates relatively. this helps UK imports to raise. good for activity.
ii. but falling £ raises UK import prices so raises inflation.
3. Case B. Responses to tariffs
a. more tariffs everywhere raise prices. inflation rises
b. but more tariffs lowers demand, so inflation falls.
c. lower demand everywhere likely has $ depreciate. Stronger £ means lower inflation.
4. The ECB-G model gives the outcome.
a. output and inflation rise initially. This is because the ECB model has a fast-moving ER channel that dominates, so £ depreciates and there is trade diversion. Thus import prices rise and so inflation rises. There is also trade diversion, which lowers inflation and monetary policy reacts.
5. now consider the case of a response. here all countries respond, activity falls and the US $ likely falls.
Now we get the opposite effect
6. what might happen to adjust these scenarios? Megan considers:
a. supply chain disruptions might lower feasible supply, pushing up on inflation
b. a flight to safety might make the $ appreciate. This is important in the ECB model which she says is dominated by the exchange rate
c. monetary policy is endogenous and passes quickly through to inflation and output.
To summarise, my understanding of this is that it looks like:
a. the SR effects in this model are driven by ERs and a bit of trade diversion. The longer term effects by monetary policy.
b. in both cases, trade diversion lowers inflation and is uneven for activity. Weaker demand lowers both.
c. But with unilateral, $ appreciates and retailation, $ depreciates.
There is a nice table summarising
with the ER movement row the crucial one.
My comment would be
1. the longer run effects of supply are neutral in most models
2. the effects on goods import prices work thru most models quickly but take a time to play out.
3. the Bank is limited in what it can do on lowering rates since core inflation is high. If that remains high, then high goods inflation will cause the inflation target to be overshot even more. Low goods inflation will hide this underlying service sector problem. That low goods inflation seems likely to be fed by trade diversion.
4. Broadly, so far this year the $ has got weaker and the £ stronger. This bears down on UK inflation.
