We review three academic papers. The first one (“The Macroeconomic Stabilization of Tariff Shocks: What is the Optimal Monetary Response?” by Bergin and Corsetti) examines monetary policy responses to tariff shocks arguing that the optimal response is contractionary for unilateral, asymmetric tariffs, but expansionary during symmetric trade wars. The second paper (“Markups and Cost Pass-through Along the Supply Chain” by Alvarez et al.) investigates the dynamics of markups and cost pass-through within the supply chain using product-level data showing that total markups remain stable over time. The final paper (“The Speed of Firm Response to Inflation” by Yotzov et al.) demonstrate that firms adjust their inflation perceptions, pricing, and expectations within days or hours of CPI releases.
Paper #1: Bergin and Corsetti (2023)
“The Macroeconomic Stabilization of Tariff Shocks: What is the Optimal Monetary Response?” by Paul Bergin (UC Davis) and Giancarlo Corsetti (EUI Florence), examines optimal monetary policy responses to tariff shocks. Using a New Keynesian framework augmented with global value chains and firm dynamics, the authors find that the optimal monetary response of the tariff-imposing country is contractionary for unilateral, asymmetric tariffs, but expansionary during symmetric trade wars.
What the paper does and main results
The paper contrasts tariff shocks with traditional supply shocks, such as productivity or markup shocks in a New Keynesian model. While the latter increase marginal costs, tariff shocks raise consumer prices (CPI) without directly affecting production costs (PPI). Instead, tariff shocks reduce export demand and prompt domestic producers to lower wages, prices, and output. This divergence between rising CPI (due to import prices) and falling PPI creates a unique inflation-recession trade-off that demands a different monetary policy response than suggested by standard supply shocks in New Keynesian models, see Figure 1. The authors argue that optimal monetary policy should be expansionary, stabilising PPI rather than CPI to support activity and producer prices despite short-run higher headline inflation.
Figure 1. Response of domestic macroeconomic variables to a 1% tariff shock under no policy (light dashed line), Taylor rule (dark dashed), and suggested optimal policy (red) in trade war.
Thus, even if imposing tariffs is inflationary, a contractionary monetary policy response is far from obvious, as this would aggravate the fall in GDP. The authors argue the optimal response to tariff shocks is determined by three key factors:
- Likelihood of Retaliation: Symmetric trade wars, involving full retaliation, depress global demand and induce PPI deflation. In this scenario, expansionary policy is optimal to stabilize output and employment. Conversely, unilateral tariffs require contractionary policy to facilitate domestic currency appreciation, offsetting the inflationary impact on imports.
- Reliance on Imported Intermediates: Higher reliance on imported intermediates (critical threshold of 54% in the model) causes inflation in domestic producer prices, shifting the optimal monetary policy to being moderately contractionary.
- Dominant Currency Role: The U.S. dollar’s role as the dominant global trade currency allows the U.S. to implement expansionary policies with minimal inflation from currency depreciation. Countries without such currency advantages, however, may adopt contractionary stances even in symmetric trade wars, underscoring the asymmetry in policy responses.
A critique of the paper
The paper has 3 main limitations. First, the assumption of perfect central bank coordination in symmetric trade wars is optimistic, as political and institutional barriers often prevent such cooperation. Second, the reliance on specific model parameters, like intermediate input shares and price stickiness, raises concerns about generalizability. Third, the role of fiscal policy, notably as tariffs generate government revenue, is underexplored.
Policy implications
The findings challenge traditional monetary policy frameworks, especially the Taylor Rule, in addressing tariff shocks. In symmetric trade wars, policymakers face a trade-off between deflation in producer price indices (PPI), a fall in domestic output and employment due to lower global demand, and higher domestic inflation. The authors suggest an expansionary monetary stance in response, even at the cost of higher short-term headline inflation.
In asymmetric tariff scenarios, the study highlights the strategic use of exchange rate adjustments to counteract distortions. If the domestic country imposes tariffs on foreign imports, domestic optimal monetary policy is contractionary for two reasons: First, domestic inflation increases but PPI does not fall. Second, divergence in the domestic and foreign policy stances will appreciate domestic currency, lowering the effective price of foreign goods to domestic consumers and thus partially offsetting the distortionary effect of tariffs on relative prices.
Putting everything together, to us, the paper provides ground for the Fed to be cautious and look through the tariffs shock, at least until it becomes clear what shock dominates and the extent of a possible trade war.
Paper #2: Alvarez et al. (2024)
“Markups and Cost Pass-through Along the Supply Chain” by Santiago E. Alvarez (University of Basel), Alberto Cavallo (Harvard Business School), Alexander MacKay (University of Virginia), and Paolo Mengano (Harvard Business School) investigates the dynamics of pricing, markups, and cost pass-through within the supply chain using product-level data for the period July 2018 to June 2023. While total markups remain stable over time, manufacturer and retail markups vary considerably and respond differently to cost shocks, reflecting asymmetry in pricing strategies across the supply chain.
What the paper does and main results
The authors examine pricing behaviors across a major global manufacturer of nondurable household products and its downstream retail partners, covering four countries: the U.S., U.K., Canada, and Mexico. The dataset combines monthly product-level records of costs and revenues from the manufacturer with retail prices collected online, allowing for a detailed study of markups at both stages of the supply chain. The key objective of the paper is to understand how cost shocks—both expected and unexpected—are passed through from the manufacturer to retailers and ultimately to consumers.
Total markups (retail prices minus production costs) are relatively stable across countries and over time, even during periods of inflation such as in 2022. The stability of total markups originates from a negative correlation between manufacturer and retail markups: when one markup rises, the other tends to fall. While one stage of the supply chain may absorb cost increases, the other passes them on to maintain stable total profitability. For example, in the second half of 2020, manufacturer markups increased while retail markups fell. In 2022, retail markups increased while manufacturer markups fell, see Figure 2.
Figure 2. Change in markups for manufacturer and retail prices. Shaded areas are 95% confidence intervals.
A critique of the paper
The focus on a single global manufacturer limits the generalizability of the findings, as the behaviors observed may not hold across other industries or sectors with different levels of competition or cost structures. The study also relies on online retail prices, which, although argued to closely reflect offline prices, might introduce biases related to e-commerce dynamics that differ from traditional retail settings. This may especially matter in high-inflation environments where offline menu costs could create significant differences to online pricing.
Policy implications
Markup changes are unlikely to drive inflationary dynamics since total markups are remarkably stable over time. For the manufacturer in the sample, the evidence clearly rejects the idea that markup increases have exacerbated inflation during the Covid period. At the same time, rising production costs are ultimately passed onto consumer and not absorbed through falling markups. Any analysis of markup dynamics should pay attention to total markups along a given supply chain since manufacturer and retail markup development may offset each other.
Paper #3: Yotzov, Bloom, Bunn, Mizen and Thwaites (2024)
“The Speed of Firm Response to Inflation” by Ivan Yotzov (BoE), Nicholas Bloom (Stanford), Philip Bunn (BoE), Paul Mizen (King’s College London) and Gregory Thwaites (University of Nottingham) examines how firms react to inflation changes based on monthly Consumer Price Index (CPI) data. Using high-frequency survey data from the UK Decision Maker Panel (DMP), the authors demonstrate that firms adjust their inflation perceptions, pricing, and pricing expectations within days or hours of CPI releases. Firms’ inflation responsiveness is characterised by higher responsiveness when inflation media coverage is elevated, a desire to maintain relative prices, a supply-side view of the economy, and expectations of higher borrowing costs when inflation is high.
What the paper does and main results
The paper investigates the rapid adjustment of firms’ inflation perceptions, own-price growth, and year-ahead pricing expectations in response to monthly UK CPI from 2022-2024. This analysis relies on the Decision Maker Panel (DMP), a monthly economy-wide survey of CFOs in 2500 UK businesses, representing around 4% of UK employment. Their event-study methodology leverages the precise timing of CPI releases and survey responses to isolate the causal impact of inflation changes on firm behaviour.
Figure 3. UK businesses’ inflation expectations and price-growth expectations track CPI realisations
According to the authors, firms update their CPI inflation perceptions almost immediately following official releases, highlighting their active monitoring of inflation dynamics. A one percentage point (pp) increase in CPI raises perceived inflation by 0.7 pp within two days (70% pass-through). Firms’ inflation perceptions are equally responsive to CPI increases and decreases.
Also, CPI changes affect firms’ expectations for their future price growth. Between 2022 and 2024, a 1 pp increase in CPI raises year-ahead own-price expectations by 0.6pp. Here, the responsiveness is asymmetric: Firms react more significantly to CPI increases than decreases. By contrast, firms showed no responsiveness during the low-inflation period of 2017-2021, underscoring heightened sensitivity in high-inflation environments.
Finally, the paper explores mechanisms driving these findings. Firms’ reactions are stronger during periods of elevated media coverage on inflation. Firms adjust their CPI expectations at a similar pace as own-price growth expectations, suggesting a desire to keep relative prices stable. Beyond inflation expectations, firms anticipate higher year-ahead input costs and lower sales growth during 2022-2024, interpreting CPI increases as supply-side shocks. They also anticipate tighter monetary policy, as CPI increases are also associated with higher expected borrowing rates. Furthermore, firms raise price expectations following currency depreciations.
A critique of the paper
While the DMP survey’s sample size is 2,500 respondents, responses in the 7-day windows around CPI releases range from 1 to 90, peaking with email reminders. This small sample size in key windows could weaken result robustness. Additionally, the authors claim representativeness without providing detailed firm characteristics, relying on indicative evidence that there are no systematic differences between pre- and post-CPI respondents.