I had an interesting exchange on Bluesky yesterday sparked by Scott Bessent’s recent comments on tariffs and inflation.
It started with Leslie Ehrlich sharing a story about a cab driver in Indianapolis who in the 1980s said something quite profound: “Inflation is a money problem. Do away with money and you’ll do away with inflation.”
The cabbie was exactly right – echoing what I wrote in a blog post last year about inflation being a monetary phenomenon (see here)
In fact, both the cabbie’s insight and Bessent’s recent comments touch on key aspects of what I discussed in that post, though Bessent’s analysis is incomplete.
In a radio interview with Larry Kudlow, Bessent stated that “tariffs can’t be inflationary because if the price of one thing goes up — unless you give people more money — then they have less money to spend on other thing, so there is no inflation.”
Let’s use the equation of exchange MV=PY (where M is the money supply, V is velocity, P is the price level, and Y is real GDP) to understand where Bessent is both right and wrong – just as I did in analyzing the general case in my earlier post. We can rearrange this as P=MV/Y.
The Part Bessent Gets Right
If we assume constant nominal spending (MV) AND unchanged real GDP (Y), then Bessent makes a valid point – tariffs would indeed only affect relative prices. When one price goes up, other prices must come down to maintain the same overall price level (given by MV and Y).
We can illustrate this with a simple two-good economy. The equation of exchange becomes:
M•V = Pa•Ya + Pb•Yb
In a barter economy (where M=0), this reduces to:
0 = Pa•Ya + Pb•Yb
Pa•Ya = -Pb•Yb
This shows that in a barter economy, if the price of good A rises relative to good B, the price of good B must fall relative to good A. We can only have relative price changes, not inflation. Here, prices are merely exchange ratios rather than monetary prices. This is similar to what happens in an economy with constant MV (and a constant Y).
The Part Bessent Misses
However, tariffs also create a negative supply shock that reduces Y (real GDP). Looking at our equation P=MV/Y, we can clearly see that for a given level of MV, any reduction in Y must mathematically result in a higher price level (P).
This is the crucial part that Bessent overlooks – even if relative prices adjust as he suggests, the overall price level will still rise due to the reduction in real GDP caused by the tariffs, for a given nominal income (MV).
The Monetary Policy Dimension
But here’s the key point for monetary policy: whether this initial price level increase turns into sustained inflation depends entirely on the central bank’s response. As I noted on Bluesky, this effect “will not continue forever if the Fed reduces M or the growth rate of M.”
If the central bank maintains a strict inflation target, it would need to reduce M to offset the negative impact of lower Y on P. However, this might not be the optimal policy response during a negative supply shock.
The Broader Lesson
This analysis demonstrates why we must always think about inflation in monetary terms.
While supply shocks like tariffs can affect the price level through their impact on real GDP, sustained inflation is always and everywhere a monetary phenomenon – it requires accommodation from the central bank.
Understanding these mechanisms – how supply shocks affect both relative prices and the price level, and how monetary policy determines whether price level changes become sustained inflation – is crucial for sound economic policy. Bessent’s analysis captures an important piece of the puzzle but misses the crucial supply-side channel through which tariffs affect prices.
A Final Note on Policy Framework – and a Warning About Protectionism
Given that President-elect Trump’s administration seems determined to pursue destructive protectionist policies – with promises of across-the-board tariffs that would significantly harm American consumers and businesses (not to mention the global economy) – it becomes even more crucial that we get the monetary policy framework right.
The negative supply-side effects of such protectionist policies would be substantial. Tariffs don’t just change relative prices – they reduce productive capacity, distort international trade patterns, and lower real GDP.
This is Economics 101, and I am quite certain that Bessent understands these effects perfectly well. His partial analysis of tariffs and inflation likely reflects political constraints rather than economic confusion – after all, it wouldn’t be wise for a Treasury Secretary nominee to publicly challenge the president-elect’s core economic agenda.
In this environment, it would be far better if the Federal Reserve operated under a nominal GDP level target rather than an inflation target. This would allow the Fed to better handle the supply shocks that inevitably come with protectionist policies, avoiding the need to tighten monetary policy in response to negative supply shocks that reduce real GDP. While NGDP targeting wouldn’t prevent the real economic damage from protectionist policies, it would at least ensure that monetary policy doesn’t amplify the negative effects.
Bessent’s politically cautious analysis of tariffs and inflation is understandable given his prospective role as Treasury Secretary. While he publicly focuses on the relative price mechanism, I suspect he privately understands the full economic costs of the protectionist agenda he would be asked to implement. Let’s hope his market experience and economic knowledge will help moderate some of the more destructive protectionist impulses of the incoming administration.
