Navigating Tariffs, Labor, and a New Inflation Regime

If you’ve been following the financial headlines lately, you might feel a sense of whiplash. On one hand, we hear about a softening labor market, which often signals economic cooling. On the other hand, consumer prices remain stubbornly elevated. Are we in a "sweet spot" for a soft landing, or are we on the brink of a more significant shift?

To cut through the noise, I’ve been reflecting on a fascinating conversation I recently heard between market strategist Lizz Ann Sonders and Freya Bemish, Chief Economist at TS Lombard. Bemish, whose work I greatly admire, provided a compelling and nuanced framework for understanding our current economic predicament—one that moves beyond simple recession/inflation binaries and points to a more profound structural change.

The Core Dilemma: A Negative Supply Shock

At the heart of Bemish’s analysis is the concept of a negative supply shock. This is different from a demand-driven slowdown, where people simply stop buying. Instead, the shock is coming from policies—primarily tariffs—that make it more expensive to supply goods to the U.S. economy.

Think of it this way: tariffs act as a tax on imports. This tax increases costs for U.S. companies, which then have two choices: absorb the hit to their profit margins or pass the costs on to consumers. Initially, amid high uncertainty, many businesses have chosen to absorb the costs, leading to a compression in profits rather than an immediate spike in consumer prices. However, the pass-through rate—the degree to which these tariffs translate into higher consumer prices—is increasing month by month.

The result? This supply shock creates inflation, which then quietly impacts demand. Consumers, facing higher prices, can’t buy as much with the same dollars. This dynamic takes a chunk out of economic growth, leading to what Bemish characterizes as a "slowdown rather than a recession."

The Labor Market’s New Math

This is where the story gets even more interesting. The recent, eye-popping downward revision of over 900,000 payrolls has sparked concern. But Bemish argues we should view this in the context of a significant shift in labor supply, heavily influenced by changes in immigration policy.

The big question is: what is the new "breakeven" rate for job growth? For years, we’ve operated under the assumption that the economy needs to create roughly 100,000 jobs per month to keep the unemployment rate stable. Bemish’s research suggests that due to a compression in immigration, that number may now be significantly lower—perhaps as low as 60,000.

This has critical implications:

• A Labor Market That Overheats More Easily: With a smaller pool of available workers, even modest job growth could lead to rapid wage increases.

• The Sticky Supply Problem: While fiscal policy can stimulate demand, labor supply is less flexible. If demand recovers but the supply of workers doesn't (or can't), the imbalance will inevitably feed into higher wage growth and, ultimately, higher consumer inflation.

Market Perceptions vs. Economic Reality

This brings us to a key disconnect. Currently, markets seem to be pricing in a "best of both worlds" scenario: no recession, but also no significant pickup in inflation. Bemish believes both risks are underpriced.

The table below summarizes the gap between current market sentiment and the potential economic reality Bemish outlines.

Factor	Current Market Perception	Freya Bemish's Outlook
Labor Market	Weakness signals a cooling economy, justifying Fed rate cuts.	Summer weakness may be an anomaly; the market is easier to overheat due to immigration constraints.
Inflation	A temporary level shift, with the rate of change stabilizing.	Risk of a sustained higher inflation rate (e.g., gravitating toward 3%) due to deglobalization.
Tariff Impact	Minimal pass-through to consumers; absorbed by corporate margins.	Pass-through is increasing and will continue, leading to demand destruction and embedding a price level shift.
Recession Risk	Low, as there are no major systemic imbalances (a correct view).	Low for now, but a trigger would be inflation hitting a ~4% handle, shifting market correlations violently.

The Fed's Unenviable Position

Given this outlook, the Federal Reserve’s path is fraught. If the Fed cuts rates aggressively based on perceived labor weakness, it could inadvertently fuel the very inflation that tariffs are introducing into the system. Bemish suggests the Fed may be tempted to "pass the buck," blaming fiscal and trade policy for inflation while focusing on supporting employment.

However, this could be a dangerous game. The moment inflation persistently ticks higher, the need for a truly independent and credible Fed becomes paramount. An "institutional attack" on the Fed’s independence, as Bemish puts it, layered on top of supply shocks, is a recipe for the kind of volatile inflation environment where "all sorts of bad things happen."

A Glimmer of Optimism: The Productivity Hope

Despite these challenges, the conversation ended on a hopeful note. Bemish is optimistic about the breakout in productivity growth the U.S. has seen since the pandemic. This was likely driven by strong, demand-led growth that the supply side could meet efficiently.

The hope is that the positive potential of AI could lead to a more diffuse productivity boom across the real economy, rather than one concentrated solely in a few tech giants. This could benefit a broader range of companies and workers, potentially offering a benign path forward if the current policy-induced supply shocks can be navigated.

The Bottom Line

The takeaway is that we are in a delicate transition. The era of hyper-globalization, which helped keep inflation low for decades, may be shifting toward a more fragmented and potentially inflationary structure. Investors should be wary of simplistic narratives and pay close attention to the interplay between trade policy, labor supply, and the Fed’s reaction function. The "sweet spot" the market is enjoying may be more fragile than it appears.

References & Further Reading:

For the latest data on U.S. inflation, visit the Bureau of Labor Statistics.

To track labor market conditions, see the BLS Employment Situation Summary.

For analysis on Federal Reserve policy, the Federal Reserve's website is a primary source.