Looking at ”Looking Through”

Happy New Year, dear reader! I hope 2025 finds you in good health and happiness. I chanced upon a discussion on whether the Fed should look through the consequences of tariffs on prices and inflation. I have written about this before and thought I should expand on the concept of "looking through".

Previously, I wrote, "If protectionist actions are merely transitory, then there is a strong case for the Fed to 'look through' the event. Looking through transitory inflation is good practice for central banks." So, what does "look through" mean? Does it mean that the Fed continues cutting rates towards normalisation, or does it mean that the Fed does nothing regardless of the tariffs' possible impact on inflation?

The answer lies in these next few points:

Nature of Inflation: Tariffs can lead to higher prices for goods, which might be considered transitory if businesses and consumers adjust over time. If the inflation is indeed temporary, the Fed might choose to "look through" it, meaning they would not adjust monetary policy in response to this short-term phenomenon.

Monetary Policy Goals: The Fed's primary goals are price stability and maximum employment. If tariffs cause inflation but do not significantly impact employment or lead to sustained inflation expectations, the Fed might decide not to react aggressively, especially if they believe the effects will dissipate.

Economic Context: The decision also depends on the broader economic context. If other factors are pushing inflation or if the economy is at risk of overheating, the Fed might be less inclined to ignore tariff-induced inflation. Conversely, if there are deflationary pressures elsewhere, they might tolerate higher inflation from tariffs.

Communication and Expectations: How the Fed communicates its view on tariffs and inflation can influence inflation expectations. If the Fed signals that it sees the inflation as transitory, it might help keep long-term inflation expectations anchored, reducing the need for immediate action. (I have written on inflation expectations in my Substack if interested).

Historical Precedent: Past responses to supply shocks (like oil price increases) might inform current decisions. The Fed has sometimes looked through supply-driven inflation if it believed the effects were not long-lasting.

International Considerations: Tariffs have international repercussions, affecting trade balances and currency values, which could indirectly influence U.S. monetary policy decisions.

Pros of Looking Through: Reacting to every price shock might lead to unnecessary volatility in interest rates, potentially destabilising economic growth. If inflation expectations remain stable, there's less need for immediate action.

Cons: Even transitory inflation can have second-order effects, like wage increases or price adjustments in other sectors, that could make inflation stickier than anticipated.

The Fed would also consider the lag in monetary policy effects; changes in rates today might not impact inflation for months or years, suggesting a cautious approach to any temporary spikes.

In summary, whether the Fed should look through tariff-induced inflation depends on their assessment of how transitory and significant these effects are, their impact on inflation expectations, and the overall economic conditions. If inflation from tariffs is seen as clearly transitory and not altering long-term expectations, the Fed might indeed choose to look through it, but they would do so cautiously, monitoring other economic indicators closely.

All this talk about "looking through" somehow reminds me of Alice Through The Looking Glass…

It's freezing here in Switzerland and I'm missing Singapore very much. Stay warm everyone :)