TARIFF PASS.
THROUGH TO CORE Pce: REVISING OUR ELASTICITY

The textbook treatment of tariff pass-through to consumer prices assumes a relatively stable pass-through coefficient: a tariff of X percent on imports raises consumer prices by Y percent, where Y is determined by the import share of consumption, the competitive structure of the importing market and the pricing power of domestic alternatives. The 2018 to 2019 tariff experience generated a substantial empirical literature that broadly found pass-through coefficients of 0.8 to 1.0 for consumer goods with high Chinese import penetration and lower coefficients for intermediate inputs.

The 2025 tariff round is different from 2018 in ways that change the standard elasticity. First, the tariff increases are larger. The 2018 round added 25 percent tariffs on specific categories; the 2025 round added 10 to 25 percent across a much broader product universe. Second, inventory buffers are different: in 2018, US importers had substantial inventory buffers and used them to absorb the tariff impact before raising prices. By 2025, post-COVID inventory optimisation means buffers are thinner. Third, supplier substitution options are different: after six years of China-plus-one transition, some supply chains have already partially moved, meaning the marginal tariff impact falls on goods that were specifically retained in China because they were difficult to source elsewhere.

The desk's revised tariff pass-through model distinguishes three separate mechanisms that operate on different timescales.

First, direct import price pass-through (0 to 6 months): the tariff is passed through to the importer's landed cost. Whether the importer passes this to the retailer and whether the retailer passes it to the consumer depends on competitive dynamics. In concentrated retail markets (electronics, pharmaceuticals), pass-through is faster. In competitive retail markets (apparel, household goods), absorption into margins is more common in the short run.

Second, FX adjustment (3 to 12 months): tariff-induced trade flows can change the relative demand for currencies, affecting the exchange rate in ways that partially offset or amplify the tariff impact. If the USD strengthens on the back of tariff-driven current account improvement, imported inflation is reduced. If trading partners retaliate with their own tariffs and the USD weakens on risk-off sentiment, imported inflation rises.

Third, domestic substitution pricing (6 to 24 months): the most important and most underappreciated mechanism. When import prices rise, domestic alternatives gain pricing power. Even if consumers switch away from the tariffed import to a domestic substitute, the domestic producer can raise prices toward the new import price ceiling. This umbrella pricing effect is responsible for a significant portion of tariff pass-through to core PCE that is not captured in import price statistics.

The desk's revised model produces a pass-through coefficient to core PCE of approximately 0.35 to 0.45 for the 2025 tariff round, compared to the 0.20 to 0.30 estimate that prevailed in the 2018 literature. The upward revision reflects: thinner inventory buffers, broader tariff coverage, the domestic umbrella pricing effect and the lower substitution elasticity for goods that survived the first round of supply chain adjustment.

At a tariff level equivalent to a 12 percent average effective rate increase on Chinese goods (a rough estimate for the 2025 round), the desk's model implies a core PCE impact of 0.4 to 0.5 percentage points over 12 to 18 months. That is not a dramatic number in isolation, but it is additive to an inflation trajectory that the FOMC was already treating as uncomfortably above target.

The timing of the pass-through matters as much as the magnitude. If the tariff pass-through arrives in Q3 2026 at the same time as the FOMC is contemplating its September cut decision, it creates a difficult sequencing problem for the Committee.

Tariff pass-through is not purely an economics question. The political economy of who absorbs the tariff cost is a contested space between the administration (which prefers the narrative of foreign exporters absorbing the cost), US importers and retailers (which prefer to absorb in margins rather than be blamed for price increases) and consumers (who ultimately bear the cost if neither of the others can absorb it).

The political pressure on retailers to absorb costs is real and quantifiable. Major US retailers publicly committed to not passing tariff increases to consumers in 2018; some were able to maintain this commitment and some were not. In 2025, with thinner margins after years of post-COVID cost pressure, the absorption capacity of the retail sector is lower.

The administration's narrative of foreign exporter absorption is partially valid: Chinese exporters competing in price-sensitive categories do face downward pressure on their export prices to remain competitive with tariff-adjusted. The desk estimates approximately 20 to 30 percent of tariff cost is absorbed by the exporter through FX and price adjustment, 30 to 40 percent by the importer/retailer margin, and 30 to 40 percent is passed to the consumer.

For rates: the desk's revised pass-through estimate adds 0.3 to 0.5 percentage points to the core PCE trajectory over the next 18 months. This is an explicit input to the FOMC reaction function and argues for caution on front-end easing positioning, particularly for the December 2026 and Q1 2027 meetings.

For equities: consumer discretionary and apparel sectors face the direct margin pressure from tariffs on goods with high Chinese import penetration. Domestically-produced consumer goods companies benefit from umbrella pricing. Industrial companies with tariff-sensitive inputs face margin pressure.

For FX: the net tariff impact on the USD is ambiguous. Current account improvement (from reduced imports) is USD-positive; growth slowdown from tariff cost and retaliation is USD-negative; and elevated uncertainty is typically USD-positive via safe-haven flows.