Trade Costs and Inflation Dynamics

We study how trade cost shocks influence inflation. Using bilateral trade flows from detailed global input-output data and a gravity framework, we estimate trade cost shocks and their effects on CPI inflation. Higher trade costs for final goods cause large but short-lived inflation spikes, while increased costs for intermediate inputs trigger more persistent inflation. A multi-country model of inflation with trade in final goods and intermediate inputs replicates these patterns. We show that trade cost shocks and tariffs on imported inputs transmit through global value chains and worsen monetary policy trade-offs. We use the model to quantify the effects of trade costs during the 2018–2019 U.S.–China trade war and to estimate the contribution of trade costs during the post-pandemic inflation surge. Novel data on U.S. domestic sourcing shares allow us to estimate trade cost shocks for the U.S. using Bayesian methods.