The average effective tariff rate for imports to the US is currently 17.9%, the highest since 19341. This includes the impact of reciprocal and sectoral tariffs, with majority of imports from India tariffed at 50% at the time of writing. US tariff revenue2 grew 300%+ y/y, from USD 7bn in August 2024, to USD 29.5bn in August 2025 and on average during May to August. However, passthrough to consumer prices so far has been very benign.
Retail inflation in core consumer goods has been rising for about a year now, but impact from higher tariffs recently is visible only in a few items like furnishing and recreational goods. However, producer prices for core consumer goods have been ticking up, and import prices moved up in July and August. This combination of retail, producer and import price movements suggests US businesses are very likely paying most of the higher tariffs. Why are US businesses reluctant to pass on higher costs to consumers, although many suggested otherwise in surveys? One, the passthrough has been delayed for various reasons. Two, the incremental impact could be more drawn-out instead of a ‘spike’ in the consumer basket in the months ahead. This may aid further rate cuts by the Fed, in line with a weakening labor market.
Can Business Profit Margins Absorb Some Price Pressures?
We know business profits picked up since the pandemic. The question we delved deeper into was whether profit margins increased, beyond that justified by fundamentals. If so, was this meaningful across sectors providing cushion now to absorb some consumer price pressure?
Methodology – We calculated wage growth by sector as the percentage change in total wage cost (using employment and weekly earnings data). Productivity growth was proxied using Real GVA growth. Inflation was then derived as the difference between wage growth and productivity growth. This derived inflation was then subtracted from the actual sectoral deflators to measure the ‘inflation gap’ (Figure 1). Higher the inflation gap, higher the actual price growth vs. that derived from fundamentals, implying higher likelihood of larger profit margins. We did this exercise for each year from 2017, to have a fair pre-pandemic reference period, till 2024.
Figure 1: Higher profit margins since the pandemic can absorb some passthrough to consumer prices
We infer the following:
1)The inflation gap during 2017-19 was negligible at the headline level and across sectors. This implies inflation was broadly in line with wage and productivity growth in the years before the pandemic.
2) The inflation gap (and thus very likely business profit margins) increased across sectors during 2021-24, at different points, vs. pre-pandemic years. For e.g., manufacturing profit margins picked up in 2021-22 and moderated in 2023-24, in line with profit level growth of 40%+ in 2021 and 2022, followed by ~5% in 2023 and -1.2% in 2024. Similarly, trade, information, professional & business services, etc. have all witnessed higher margins.
3) Construction and Education & health services (latter an acyclical/defensive sector) are the major exceptions without any material gains. So, profit margins of most cyclical sectors have remained healthy.
4) None of the sectors had a material drop in margins in recent years, thus not offsetting any gains since the pandemic, although business profit growth of late has been more narrowly driven by financial institutions and information/tech.
This implies most business-sectors can absorb some price hike from tariffs, against their higher profit margins since the pandemic. This includes goods-oriented sectors like manufacturing and trade.
Other Factors In Play
While higher profit margins are one of the major reasons for weak passthrough, there are several other factors too. Inventory frontloading and uncertainty on sustenance of various tariff rates, as negotiations are underway, are well documented. The price impact could also be dampened through adjustments to quality, sourcing location and sales-offers to push higher quantity. A recent report by the San Francisco Fed also found import content is much lower for consumption goods, which have a sizeable share of domestic transportation costs and markups, implying lower tariff passthrough compared to investment goods. Further, the actual effective tariff rate on the ground (calculated for July using latest available data) is only ~10%, much lower than 17.9%. This is possibly due to exemptions, some re-routing, and the real cutoff date being 05th October (not 07th August) for most of the latest tariff rates to take effect, because goods in transit before 07th August and landing in the US before 05th October are not charged the new rates. The impact of the latest rates could therefore be felt only in late 2025 or early 2026, given the time it also takes from landing at the port to hit the retailer.
Another major factor we have written about previously is weaker consumer demand. Delinquency rates in auto, credit card and student loans have risen, particularly in the lower income segments. Home affordability is low and the wedge between asset owners and others have widened. Consumption of services, by volume has been moderating (Figure 2). Labor market has been weakening more visibly now. Re-employment has become difficult and unemployment rate by race/ethnicity has diverged sharply vs. the aggregate number. Job additions are much lower and narrowly driven by acyclical sectors like education & health care while most cyclical sectors have shed jobs. In fact, the divergence between weaker commentary in the Fed’s Beige Book (which compiles anecdotal information on economic conditions) vs. buoyant hard data is widely attributed to this cyclical-acyclical gap. Acyclical factors have also been bigger drivers of inflation (Figure 3). Recent PMI output-prices readings have also eased, suggesting modest passthrough. All this points to weaker and narrower underlying growth, a major aspect in firms’ pricing decisions.
Given all these reasons, passthrough of higher tariff rates to consumer prices has been delayed and is likely to be more drawn-out, with possible intermittent increases and less extreme jumps. The final impact will depend on the import share and tariff rates (of products), the profit margin and market share (of companies), and final demand (of consumers).
Drawing comfort – The Fed and the Rate Trajectory
According to the Fed, higher tariffs have begun to impact inflation only in some categories, as US businesses are likely absorbing a good part of higher costs, although near-term inflation risks are to the upside. Its base case is inflation from tariffs is relatively short lived, a one-time effect, given inflation expectations for the shorter term have picked up but those for the longer term is consistent with the 2% target. It recently noted risks of higher and more persistent inflation (the Fed’s job being to prevent second round effects) have eased since April. Even inflation expectations of the swap market are lower for the second year vs. first year (Figure 4), implying lower persistence. In fact, both 1y and 2y expectations have eased in the last month, after the spikes related to tariffs and income-tax-cut extension.
In the context of a visibly weaker labor market which shifted the balance of risks, the Fed cut rates earlier this month. It has also relied more on real-time data, given high uncertainty around forecasts. If labor market conditions remain weak or ease further, a moderately elevated CPI trajectory instead of a sharp jump due to higher tariffs, andclower likelihood of second round effects could put the Fed’s dual goals in less tension. This, ceteris paribus, supports further rate cuts and a weaker US Dollar, which aids capital flows to Emerging Markets.
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