A note on tariffs from the real world

I had an interesting correspondence with the CEO of a fairly large retailer, in response to the latest Goodfellows. He/she and it will remain anonymous for obvious reasons. It informs a lot of important economic questions.

…as I hear Sir Niall say that there has been no impact from tariffs…it’s coming, and it’s a tidal wave for the American consumer. All tariff pauses just ended on August 8…we all brought in as much previously (lower) tariffed goods before that, and most fall merchandise was here in the spring and early summer…so we are still selling goods that didn’t have the latest tariff burden. But we are all raising prices slowly and carefully as the tariffed inventory gets sold (remember, accounting wise, we have a cash hit paying tariffs upon receipt, but we have a P&L hit when we sell the tariffed goods). You will start to see the margin hits a little in 3Q and a lot in Q4. But…we are all trying to hold prices through the key holiday … because we all believe the American consumer is going to be smacked by raised prices everywhere. So many are holding back to try to eke out a good holiday. But we all know that come January, we have massive margin hits (our sector was already the highest tariffed at ~12%, and now sits at ~33%), consumer slow down, and we have to raise prices roughly 10-15% to cover tariffs…and we also all know that our elasticity is roughly -1.0… so there is a major shock to retail and the economy coming…it’s just masked right now because we are selling older inventory, and trying to hold prices for holiday.

The main issue, of course, is why tariffs have not shown up yet in inflation. This CEO’s answer is, just wait, it’s coming early next year.

The email is revealing on one of the central puzzles of macroeconomics, how “sticky” prices are, how quickly or slowly rising costs show up in prices, and why. I quickly followed up:

As an economist, I’ve always puzzled that companies seem to raise prices only when their inventory changes over to new inventory bought at higher prices. Surely, we all see higher prices coming and should raise prices now. Apparently not… I presume you really don’t want to piss off your loyal customers until you really have to. Economists have long puzzled that tariffs and exchange rates pass through slowly to prices.

To clarify: You have an inventory of widgets, which you bought at $1 each. The cost of widgets goes up from 90 cents to $1.50 because of tariffs or an exchange rate change. All your competitors face the same costs. Do you raise prices immediately to $1.60, and book a profit on your inventory? That’s what economics would suggest. Or do you wait until the 90 cent widgets run out and you have to start selling $1.50 widgets to do it? In response to my follow up,

We did raise prices before the P&L hit to get a running start at protecting our bottom line - we raised prices in 60% of our items a blended 10%. And we are seeing a worse negative elasticity so far (-1.3) which is scary because unit volume decline means customer decline which means a negative spiral for next year…starting with fewer customers to re-engage.

This is a business with a lot of loyal customers (including me). So I’m interested that sales fall so much even though we all know the goods are imported and so are the competitor’s goods. It’s interesting how the accounting treatment of bottom line matters. A pure economist would immediately mark up the current inventory to its opportunity cost, $1.50, not its historical cost, book a windfall profit, and then mark any sales below that value as losses. Business only raise prices when accounting losses force them to do so.

There is of course no “Calvo fairy” stopping these companies from changing prices. A lot of sales are online, so no “menu costs” either. The general picture of “customer markets,” especially in goods that people buy year after year, or “don’t piss people off until you have to” rings true. I suspect higher prices make people leave more quickly than lower prices make them come. Then, the cost of losing a customer now is a lot of future sales. Also “strategic complementarity.” Clearly, this business and its competitors could all raise prices at the same time, but nobody wants to move first.

It’s interesting that US retailers selling imported goods and foreign firms behave so differently. I’m shopping for another good, which is made in Germany and exported directly to consumers. It’s priced in euros, and I pay tariffs. Instant pass through. It did not begin to occur to this company or its competitors to insulate their faithful American customers from tariffs and exchange rates. They also suffer drops in sales when price go up, but tough.

Update: A correspondent writes

My flower bill just came in from the nearby nursery and it added a 6% tariff charge at the bottom so I could see it

Some businesses are adding tariffs as an add-on to the price. San Francisco restaurants did that too, in response to various state and city mandates. Saying “we’re not taking advantage of you we have to do it because our costs went up” seems to be effective, and helps to explain why businesses are otherwise reluctant to change prices.