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• Are Firms Factoring Increasing Inflation Into Their Prices?

Transcript

Tim Sablik: My guests today are Zach Edwards and Felipe Schwartzman. Zach is a research analyst and Felipe a senior economist, both at the Richmond Fed. Zach and Felipe, thanks for joining me.

Zach Edwards: Hey Tim, good afternoon. It's great to be back on the pod.

Felipe Schwartzman: Happy to be here.

Sablik: We're going be talking about how businesses do — or don't — change their prices in response to rising costs or expectations of higher costs in the future. This is something that you've both been writing about recently, particularly in the wake of significant changes to U.S. tariffs over the first half of this year, and that's where I want to start.

Zach, you've been involved in analyzing the responses the Richmond Fed has been collecting from its business surveys. What are firms saying about how they expect to be impacted by tariff changes, and how have those expectations evolved over the course of this year?

Edwards: To answer this question, let's first go back six months to February. We began seeing changes to trade policy. It started with tariffs against China, Canada, and Mexico — in addition to tariffs on steel and aluminum imports — which would end up getting delayed until March.

While our February business survey showed a slight upturn in firms' expectations for cost and price growth, there was no clear evidence yet of widespread growth in either, which makes sense. Firms were reacting to announced changes in tariff policy that hadn't yet taken effect. However, firms did note that if costs were to increase by more than anticipated, they plan to pass through all or more of the increase in costs by increasing the prices that they charge their customers.

Then, March rolls around and the aforementioned tariffs on Mexico and Canada, and global steel and aluminum go into effect. At this point, the tariffs still hadn't begun biting for most firms responding to our business surveys, though the majority of respondents reported that they expected to be negatively impacted.

Though we saw a drastic increase in firms' expectations for cost and price growth — especially cost growth — the prices that firms were actually paying for their inputs hadn't risen nearly as much as their expectations had. This was in part due to the fact that many firms reported front-loading inventory purchases before tariffs took effect. Lots of firms were taking a wait-and-see approach, while others were attempting to identify alternative suppliers not subject to tariffs. In total, we found that only about 20 percent of respondents to our March business surveys had increased prices due to tariffs.

Fast forward a few months to June. Roughly three-quarters of respondents had adjusted business operations due to tariffs. That includes 37 percent of respondents — up from 20 percent in March — that had increased prices due to tariffs and a majority that planned to increase prices. In addition to adjusting prices, firms widely reported more front-loading of inventory purchases, canceling or delaying capital expenditures, and changing hiring plans, many citing uncertainty around trade policy as a rationale for putting business plans on hold.

That long and winding answer brings us to the present. I should add a quick disclaimer that the results I'm sharing now are from our August surveys, which closed roughly a week after we're recording this. So, we have a pretty good sense of what the data is telling us, but the numbers are preliminary and subject to change.

What we're seeing so far in our August survey data is that firms remain uncertain about the path of input costs throughout the remainder of the year. They're just not sure exactly how the tariffs will impact the cost of their inputs, and that makes it difficult for them to plan. However, we are seeing evidence that firms are [passing] or plan to pass along some or all of the additional costs associated with tariffs.

Sablik: Thanks very much for that overview of all the changes. It sounds like, as you said, firms have said they've expected to pass on higher costs, but there's some uncertainty about when or if those higher costs will hit. Are we seeing more evidence about firms saying they're expecting to pass on higher costs to their customers through price increases soon?

Edwards: Yeah, absolutely. Again, these results are preliminary. About 25 percent of respondents in August so far saw increases in input prices because of tariffs and were able to pass some or all of them through to customers. A share of the cost increases that they were able to pass through varies pretty widely. However, most of these firms anticipate increasing prices again later this year. Another 20 percent of respondents noted that their costs had increased, but they hadn't yet passed them through to customers. Most of these firms anticipated raising prices at some point this year, though.

So, although we're seeing evidence that some firms are passing through and planning to pass through tariff-related costs to their customers, it isn't yet a widespread phenomenon among our survey respondents. For some firms, increasing prices is a bit of a gamble. As one business put it, "Tariff costs transferred to our customer is creating the largest earnings uncertainty in our 2026 business plan."

Sablik: Felipe, you've written recently about the role that firm pricing decisions play in overall inflation, particularly in the context of the higher inflation that we saw during the pandemic recovery. What are the factors that firms weigh when they're deciding whether to pass on increased cost to customers?

Schwartzman: I think the first thing that they're worried about is, what are their competitors doing? If everyone is increasing their prices, then you're not going to lose much by increasing your price.

I should backtrack for a second and say, why is it that firms would not increase their prices? It's because they fear losing customers. So then, the first thing they think about is what their competitors are doing, right, because you're going to lose customers to a competitor if you're the only one doing it.

The other thing — and this is also related — is, are your customers going to go to their competitors if they think your competitors may not be increasing their prices while you are? One way to make sure that this does not happen is if you're very clear to your customers that this is something that everyone is going through. When it's a very visible thing, like a tariff or like an oil price change, there's more of this sense of everyone is increasing their prices. Where are customers going to go? They might as well stick to what they know, right?

The third thing I would say is firms don't usually want to adjust their prices to things that are temporary. If you think your costs are going up right now and they're going to go down later, perhaps you just keep your prices where you are and you don't risk alienating your customers. If you think these things are going to be more persistent or are going to be larger or a bigger deal, even if they're not a big deal right now, then perhaps you may want to get ahead of the curve and get your prices in place.

Where we're trying to gauge a little bit is, how are they forming these expectations and how are they forming these views? Where firms are focused very narrowly on their own little silos and thinking of what's the cost of my own materials and my own cost of doing business and the workers that I need, this is a world where you worry a little bit less. Firms may be thinking, "Perhaps that's true for me. That's not true for my competitors." Perhaps one firm is seeing something go up and another is seeing something go down.

In a world where firms are looking at the Fed and thinking it all depends on which way the Fed goes in whether inflation is going to go up or not overall, that is a world where you worry. Everyone is increasing their prices and then the whole thing can feed on itself.

Sablik: In terms of the Fed's policy mandate on looking at overall inflation, Zach mentioned and you were talking about how firms are considering a lot of different factors. Some firms are raising their prices, some are waiting. If firms do start to raise prices, does that necessarily translate into higher overall inflation or is the relationship a little more complicated?

Schwartzman: I don't think it's that complicated. Inflation is just firms raising their prices overall. If a lot of firms, all of them, raise their prices at the same time, you get inflation. If they don't, you don't. The question, again, is how persistent this is.

Some analysts think you just increase your prices by enough to absorb the tariffs and then you move on. That's a benign scenario because the U.S. imports 20 percent of its GDP and the tariffs are affecting that bit of the U.S. economy more directly, so you get a few percentage points increase in the price level. You spread this out over a few months. Everything becomes more expensive, but not in the sense of what inflation looks like going forward. The bigger deal is if this starts feeding on itself and becomes a more persistent process.

Sablik: We're recording this on Aug. 12, the day that the CPI numbers for July just released. So far, inflation through this year has been relatively steady. Is that in part because firms haven't yet been passing on higher costs, or is it still too early to tell what dynamics are going to play out there, like you were saying?

Schwartzman: I think there's a lot of waiting to see. From an implementation standpoint, it takes a little bit for tariffs to show up in the goods that are being imported. Then, once you import those goods, these things are going to feed through the supply chain.

I think there's some uncertainty about, more generally, the state of the economy. You had some bad employment reports recently, so firms may also be wondering, is [now] the best time to increase my prices if the economy is going to perhaps go into a recession? So, there's a lot of uncertainty. One way to deal with uncertainty is to wait and see.

Edwards: I can add a little bit of context from what we're hearing from our business contacts. Like Felipe said, there are a lot of reasons why businesses may not have begun increasing prices yet.

As I mentioned before, many firms have front-loaded inventory purchases, so they've been operating off of non-tariffed inventories. Others have pricing structures that don't allow them to readily change prices, like annual contracts. Some are in wait-and-see mode, like Felipe said, absorbing tariff costs now. But they might plan to make up margins later in the year if tariffs stick. We've also heard accounts of businesses spreading out tariff costs associated with one product by increasing the price of multiple products to make the sticker shock for customers a little bit less daunting. So, all these might be contributing to the lack of changes we've seen in headline inflation.

Sablik: One of the things you ask in your surveys is about what firms' inflation expectations are. What are you hearing from businesses on that?

Edwards: We asked firms once per quarter in our business surveys about their expectations for inflation over the next year and then over the next five years. The last time we asked was in July, and that data suggests that firms, on average, expect inflation to be between 3 and 4 percent over the next year and five years. There's a lot of uncertainty around these forecasts, so don't necessarily take those numbers to heart.

These numbers are higher than they were this time last year, particularly for inflation over the next year. But they've come down since April when we last asked the questions.

Interestingly enough, the decrease in expected inflation over the next year was particularly noticeable among manufacturers, which our surveys have indicated have been most directly impacted by tariffs. It's important to note, though, that just as heightened uncertainty makes it difficult for firms to plan for their own future, it also makes it difficult to forecast price growth for the economy. Providing an estimated inflation rate is beyond a guess. It's comparable to throwing a dart in the direction of a dartboard while blindfolded. So, these are difficult forecasts to make.

Schwartzman: We have the special questions. One of the questions is specifically about whether they're looking at overall inflation trends. This gets back to the point I was making about you don't want processes that feed on itself — letting inflation trends affect your pricing decision, which, of course, is what makes inflation go up. I don't think it's raising alarm bells in the way that this was in the pandemic inflation surge, but it's definitely something to keep an eye out for.

Sablik: As you mentioned, this can be a self-reinforcing process, right? Higher inflation expectations might make firms more likely to increase their own prices, which then feeds into higher inflation.

Schwartzman: And then, of course, workers [are] demanding higher wages or looking for other jobs so that they can get a wage adjustment. That puts extra cost pressures. These are the things we worry about.

Edwards: We asked firms how important different things are when they're setting their own prices. One of those things we ask about is, how important are aggregate measures of inflation? How important are competitors prices? How important are changes in labor costs?

There has been a slight uptick in the importance of aggregate measures of inflation when firms are setting their own prices, but it's still solidly the least important thing out of the list that we give them to choose from. Things like changes in demand, labor costs, and non-labor costs are still pretty consistently the most important factors for firms' own price setting.

Sablik: Zach, what do you and the rest of the survey team plan to ask firms about their pricing decisions in the coming months?

Edwards: That's a great question, and it's one that I don't have an exact answer to. We're continually asking firms about their forecast for cost and for price growth. But we also like to throw in a slew of what we and Felipe have called special questions that reflect the economic issues of the day, which today are tariffs.

In addition to learning about how firms are thinking about price setting, we're also interested in monitoring how price setting translates to things like consumers' demand for businesses goods and services and businesses' demand for labor, both of which we may ask about in upcoming special questions. So, stay tuned for those results and to find out what we learned.

Sablik: Felipe, what sort of data on prices and cost pass-through will you be watching as you and your fellow economists try to forecast where inflation might be headed next?

Schwartzman: One kind of thing we've been trying to look into is, how do sectoral prices change and vary depending on how affected they are by tariffs? You would expect that as tariffs increase, the sectors that are more affected by tariffs — either because they use more imported inputs or because they use more inputs that use imported inputs and so on — to have a higher price increase than sectors that are very insulated. So with your haircut, you shouldn't expect to see that much of a price increase necessarily, whereas with cars you might expect to see quite a bit. This difference tells us something about just how much firms are passing through these tariffs into prices.

The second thing this also tells us is that if you also see the price of haircuts going up, that starts raising the alarm bells, right, because that's telling you that you're going beyond these first-round effects from tariffs.

Marina Azzimonti has a bunch of Economic Briefs that she has been writing about all the work she's been doing on finding these impacts. I think we're trying to bring this together with sectoral pricing indices. So, stay tuned.

Sablik: Very interesting stuff to continue watching and I definitely appreciate, Zach and Felipe, both of you coming on to join me and talk about it today.