A recent analysis by economist Robin Brooks highlights how U.S. tariffs are creating a sharp divergence in global price pressures. His examination of June PMI flash data shows output prices rising sharply in the U.S., while “doing nothing” in the Eurozone, UK, and Japan. This divergence suggests the Federal Reserve and most forecasters may be missing a crucial dynamic in their inflation projections.

The Deflationary Reality Hidden in Plain Sight

Brooks’ PMI analysis reveals that tariffs are deflationary for foreign producers, forcing them into intense price competition to maintain market access. Chinese manufacturers are experiencing their worst contraction since 2022, with export orders plummeting as they scramble to remain competitive despite tariff barriers.

Across global markets, producers are cutting prices, improving efficiency, and accepting lower margins rather than losing market share entirely. The result? More price competitiveness, not less—exactly the opposite of what inflation hawks are predicting.

The Triple Deflationary Force

While the Fed obsesses over tariff-driven price increases, three powerful deflationary forces are aligning:

Lower Interest Rates: Despite the Fed’s caution, market expectations for rate cuts persist, with participants pricing in two cuts by year-end. Lower borrowing costs historically correlate with deflationary pressures as economic activity moderates.

Oil Price Volatility: While energy markets were previously signaling weakness, the ongoing Israel-Iran conflict has created significant volatility, with oil prices surging over 20% in June before falling back toward pre-conflict levels around $67/barrel following ceasefire developments. However, longer-term forecasts still point to Brent crude declining to $66/barrel by 2026, assuming geopolitical tensions stabilize.

More Price Competitiveness: While Brooks’ data shows output prices “doing nothing” in the Eurozone, UK, and Japan compared to sharp U.S. increases, this regional divergence suggests that tariffs are creating deflationary impacts on foreign producers—which should lead to more price competitiveness and somewhat restrained price increases, countering the inflationary pressures that dominate current forecasts.

The Fed’s Fundamental Misread

The Federal Reserve’s latest projections show core inflation rising to 3.1% in 2025, driven by expected tariff impacts. This forecast reflects a static view that ignores dynamic competitive responses and global price pressures.

History suggests this approach is flawed. The 1930s tariffs ultimately proved deflationary rather than inflationary as global trade contraction and competitive pressures overwhelmed initial price increases. Today’s interconnected economy could amplify these effects.

The Key Question

The real question isn’t whether tariffs will initially boost some prices—they will. It’s whether the combination of deflationary forces will ultimately prove stronger than the inflationary pressures that drive current Fed projections.

The Policy Risk

By maintaining a hawkish stance based on inflation projections that may prove too high, the Fed risks being poorly positioned if deflationary forces gain momentum. If the combination of lower interest rates, falling oil prices, and increased price competitiveness creates disinflationary pressure, current monetary policy assumptions could prove problematic.

However, this deflationary thesis faces two significant policy risks that could reverse the dynamic entirely:

Tax Policy: The failure to extend the 2017 tax cuts would increase the tax burden on businesses and individuals, potentially reducing economic activity and altering inflationary dynamics in ways that could validate the Fed’s current inflation concerns.

Regulatory Challenges: Successful legal fights against deregulation efforts could increase business costs and regulatory burdens, contributing to inflationary pressures that would undermine the deflationary forecast.

If either of these policy reversals occurs, the economic calculus could shift back toward the inflation scenario that currently drives Fed thinking, making their hawkish stance appropriate rather than problematic.

Bottom Line

The Brooks data on divergent price pressures highlights a potential flaw in consensus inflation forecasting. While the Fed and most analysts focus on domestic tariff impacts, they may be underestimating the deflationary forces building in global markets.

The combination of increased price competitiveness from foreign producers facing tariff pressures, volatile but potentially lower energy costs, and eventual interest rate cuts suggests disinflation rather than the persistent inflation that currently drives policy thinking.

However, this deflationary outlook hinges on maintaining current tax and regulatory policies. The expiration of 2017 tax cuts or successful legal challenges to deregulation could shift the dynamic back toward inflation, validating the Fed’s current concerns.

The question is whether policymakers will recognize this conditional relationship—and whether policy continuity will allow deflationary forces to prevail over inflationary expectations.

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