Congressional Budget Office: President Trump's Tariffs Are Pushing Inflation Higher But Could Also Cut Deficit More Than Expected

Key Points

• Much debate has ensued over whether President Donald Trump's tariffs will lead to a significant increase in inflation.

• The Congressional Budget Office (CBO), which looks at the financial impact of Congressional bills and other policies, said inflation has come in higher than it expected.

• However, the CBO also expects tariffs to bring in more revenue than expected.

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The constantly changing nature of President Donald Trump's tariffs, a signature of Trump's negotiating style, has made it difficult for investors to understand the long-term impact of the tariffs. While inflation is still comfortably above the Federal Reserve's 2% preferred target, many experts and analysts have found inflation from tariffs to be tamer than expected.

However, a recent report from the non-partisan Congressional Budget Office (CBO) suggests that inflation from tariffs has been higher than the agency expected, but also that tariff revenue may bring the deficit down more than expected over the next decade. Let's take a look.

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Official White House Photo by Joyce N. Boghosian.

Inflation coming in higher than expected

The purpose of the CBO is to assess the impact of laws and policies implemented by the President and Congress on the U.S. economy and U.S. budget to provide lawmakers and individuals a better idea of what's actually going to happen.

There's been wide debate over whether Trump's widespread tariffs will increase inflation or not, and potentially by how much. Many economists and Fed Chair Jerome Powell have said that tariffs, at the very least, are likely to result in a one-time increase to inflation, although there's a lot of uncertainty about when this will happen, and it also may not all happen all at once, potentially making the impact feel more prolonged.

But so far, while inflation has increased in recent months, many economists and market strategists say the impact has been more muted than expected. The CBO now projects inflation to hit 3.1% by year end, up from its previous estimate of 2.2% in January -- the CBO only updates inflation expectations a few times a year and obviously a lot has changed since January.

"It's lower than what Wall Street expected, but higher than what we expected and it's probably the tariffs," CBO Director Phillip Swagel said in a recent interview with CNBC, adding that the CBO assumes current law in its modeling, while Wall Street doesn't have to do this. "The economy has been weakening over the course of the year, and you'd expect that to lower inflation, but the tariffs have probably been pushing up inflation. You know not by a lot but by enough to show up in the numbers."

Still, in the CBO's recent expectations for the economy from 2025 to 2028, which was published on Sept. 12, the agency said they expect the impact on inflation from tariffs to be temporary.

Potential to cut the deficit by $4 trillion over 10 years

In other updated projections, the CBO now expects revenue collected from Trump's tariffs to come in higher and cut total deficits by more than expected. The CBO expects primary deficits to come down by $3.3 trillion over the next decade, which will lower interest costs by another $0.7 trillion, leading to a decrease in total deficits of $4 trillion. In early June, the CBO had only called for a deficit reduction of $3 trillion including interest costs. The CBO added that its estimates "are subject to significant uncertainty, largely owing to questions about timing, possible exceptions, and a lack of precedents."

It's also important to note that Trump's large spending bill passed by Congress earlier this year is expected to increase total deficits by $3.4 trillion between 2025 and 2034, due to a reduction in spending of $1.1 billion and lower revenue of $4.5 trillion. So if you put together Trump's tariffs and budget bill, the net impact would be a $0.6 trillion decrease to the U.S. budget deficit over the next decade based on the CBO's projections.

That would still be very significant, considering the deficit in fiscal year 2025 so far is roughly $1.97 trillion, and in January, the CBO projected the annual deficit would rise to $2.7 trillion by 2035.

How this could impact the stock market

The question of whether the U.S. government's worsening debt situation will become a major problem or not is still very controversial among investors. Some are very worried, while others say the U.S. is more insulated from these issues than other countries because the dollar is the reserve currency of the world.

In the near term, the Supreme Court has decided to fast track an appeal by the Trump administration over a court ruling that determined Trump did not have the power under the International Emergency Economic Powers Act (IEEPA) to implement most of his tariffs. The U.S. Court of International Trade (CIT) first made the ruling, and the decision was upheld by the U.S. Court of Appeals.

If the Supreme Court were to uphold the decision by the two lower courts, the U.S. government might need to refund up to $1 trillion of tariff revenue. I don't think the stock market would react well to a decision like this because Trump's big tax bill would still be in place, so the projected deficit would likely rise significantly over the next decade without the tariff revenue.

If this scenario did play out, Congress could pass a corporate tax increase to offset lost tariff revenue, but that could be difficult from a political standpoint, given Republicans' history of opposing tax increases. While I am not sure exactly how the Supreme Court will act, six of the nine judges were appointed by Republican presidents, including three by Trump.

A good hedge on a Supreme Court decision affirming that Trump did not have the authority to implement most tariffs would be to buy gold, which has rocketed higher in recent years. Investors have poured into gold, partly over concerns about U.S. budgetary issues that could lead to high inflation.

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Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.