How Tariffs Lower Inflation Without Hurting the Economy
The San Francisco Federal Reserve’s paper on tariffs leaves us with a puzzle: why do tariffs affect the economy in such a counterintuitive way?
Looking at 150 years of data, the researchers at the San Francisco Fed found that tariff hikes are followed by lower inflation and higher unemployment. That runs contrary to the widespread assumption that tariffs might result in higher levels of employment but at the cost of higher inflation.
The authors of the paper say they think this might be a demand-destruction story: tariffs scare investors, tighten financial conditions, and reduce aggregate demand. They point to two possible channels: increased uncertainty about economic policy and declining asset prices. In either case, they think the result would be less investment and spending, resulting in fewer jobs and lower prices.
It’s a plausible interpretation. But there’s another one that fits the San Francisco Fed’s results even better—and better explains the actual policy mix Trump is deploying. It starts with a simple observation: the American economy, particularly in tradable sectors, has spent decades locked into a low-wage, low-productivity equilibrium. But this is not the only—and certainly not the best—way to run the economy.
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The Path Toward Low Wage, Low Productivity America
With tariffs low and borders open, domestic firms faced a relentless downward pressure on price and costs. Foreign competitors offered rock-bottom costs. The easiest way to compete was obvious: keep wages down, skimp on capital investment, and hire lots of low-skill workers. Call it the low-wage equilibrium. Wages stay depressed. Productivity per worker stagnates. Employment is high in raw numbers, but the jobs are often unstable and poorly paid.
This, in essence, is what “competing with China” meant in policy debates: we imported the low-wage production model directly into our own labor market.
Now imagine what broad tariffs actually do to that setup.
The Structural Shift Toward Higher American Productivity
When you impose a general tariff increase—not a carve-out for one industry, but a comprehensive one—three things change simultaneously.
First, foreign cost pressure eases. Domestic firms no longer need to match China’s price to survive. The brutal race to the bottom on wages becomes less binding.
Second, workers’ bargaining power rises. Employers can no longer credibly threaten to source overseas. More importantly, the political act of raising tariffs sends a signal: the full faith and credit of the American people is backing domestic production. That shifts leverage in wage negotiations across the entire tradable sector and, because workers can move between sectors, spills into services as well.
Third, cheap labor becomes relatively expensive compared to capital. With the wage floor rising and the supply of low-skilled workers finite, the “just hire more bodies” model stops making economic sense. The alternative path of investing in machines, reorganizing production, training workers, and deploying better logistics suddenly looks far more attractive.
Add in the rest of the policy package—restricted low-skill immigration shrinking the inflow of wage-depressing workers, immediate expensing and lower taxes on capital, and pressure for lower interest rates—and the choice becomes obvious. Firms stop trying to run domestic sweatshops and start buying capital and raising productivity.
In this supply-side interpretation, tariffs don’t primarily crush aggregate demand. They fundamentally change how we produce.
Firms shift from many low-productivity workers with minimal capital and minimal wages to fewer workers with more capital per person, higher productivity, and higher wages. The implication is stark: some jobs disappear—specifically, the worst jobs at the bottom of the productivity ladder. The remaining jobs are more productive and better compensated. Output doesn’t collapse; it may even rise. But you need fewer workers once you’ve upgraded the capital stock and reorganized processes.
This alone generates higher measured unemployment, even if total output is rising. Some of the low-skill, low-productivity jobs go away and some people get trapped in the transition. But this is likely a temporary phenomenon. As the economy shifts toward rewarding investing in higher productivity and domestic manufacturing, the workforce will shift along with it, bringing back in workers.
So, the unemployment effect in the San Francisco Fed paper is exactly what you’d expect from a structural shift away from unproductive jobs, not from a generic demand collapse.
Why Prices Fall
Now comes the trickier part: squaring tariffs with disinflation.
The standard objection is that tariffs raise costs and therefore should raise prices. Yet the San Francisco Fed finds the opposite over the long arc of history. How do we resolve this?
The key is unit labor cost—the wage expense required to produce one unit of output. It’s a simple formula: wage per worker divided by output per worker.
Tariffs combined with Trump-style policy push on both sides of that equation simultaneously. Wages rise because workers gain bargaining power inside the tariff wall and reduced low-skill immigration tightens the labor market from below. Productivity rises because firms respond to higher wage pressure and cheap capital by investing in machines, training, and software. Output per worker climbs.
Here’s the critical insight: if productivity rises more than wages, unit labor costs actually fall. Even though workers earn more per hour, each unit of output becomes cheaper to produce.
In competitive or semi-competitive markets, firms can’t sit on lower unit costs indefinitely. Those savings show up as either lower prices than the old models predict or much weaker pass-through of tariffs into consumer prices.
That’s very likely why the San Francisco Fed finds disinflation rather than inflation after tariff hikes. You haven’t just destroyed demand. You’ve moved the entire supply side from low-productivity to high-productivity. Costs per unit are lower even though wages are higher.
In short, the mechanism works like this: tariff shock plus fewer low-skill workers plus cheaper capital produces capital deepening and higher productivity, which lowers unit costs, which generates disinflation, not inflation.
Two Stories, One Data Set
This matters because both interpretations can fit the San Francisco Fed’s impulse responses. You can describe the same results in two languages:
In the demand-destruction story, tariffs frighten investors, hurt confidence, and tighten credit. Households and firms cut spending. Lower demand produces higher unemployment and lower inflation.
In the supply-side story, tariffs, immigration limits, capital tax cuts, and pressure for lower rates combine to make low-wage, low-productivity production uneconomical. Firms invest in capital and reorganize. Low-productivity jobs disappear while high-productivity jobs grow. The transition produces temporary unemployment, but the new supply side has higher real wages and lower unit costs.
The question is which story better matches the policy mix we actually see and better accords with long-run outcomes. Trump’s program pairs tariffs with immigration restrictions, capital incentives, and monetary easing. The long-term political economy shows the country has shed bad jobs while raising real wages for workers who remain.
On both counts, the supply-side story wins.
That doesn’t mean every imaginable tariff is justified—we probably should not have tariffed coffee or bananas—or that current levels are optimal. Maybe tariffs should be set a bit higher given our still too-high level of inflation.
It means the San Francisco Fed’s paper shouldn’t be read as evidence that tariffs work only by beating demand over the head. It should be read as evidence that tariffs, paired with immigration policy, capital policy, and monetary policy, are tools for breaking a low-wage equilibrium and pushing the economy toward more capital, more productivity, higher real wages, and a cooler price path.
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