In the realm of economic policy, there are times when ambition and political rhetoric can overshadow basic numerical coherence.

President Donald Trump’s recent declaration at the World Economic Forum in Davos that he will “demand that interest rates drop immediately” while simultaneously championing protectionist tariffs is a glaring example of this kind of inconsistency (see here).

This is a policy cocktail that risks sending the U.S. economy down a precarious path, eerily reminiscent of Turkey under President Erdogan.

In his speech, Trump did not explicitly name the Federal Reserve but made it clear that he intends to exert pressure to bring down interest rates, stating, “Interest rates should follow us all over.”

This statement, coupled with his frequent criticisms of Fed Chair Jerome Powell—including calling policymakers “boneheads”—illustrates the contentious relationship he has maintained with the central bank.

Trump’s remarks come as markets anticipate the Fed’s upcoming policy meeting, where traders see almost no chance of further rate cuts despite his demands.

Let’s dissect why this approach is economically self-contradictory and potentially disastrous.

The Tariff-Interest Rate Nexus

Every time President Trump amplifies his “I love tariffs” rhetoric, U.S. Treasury yields have tended to rise.

This is no coincidence. The U.S. trade deficit is effectively mirrored by foreign financing of the American budget deficit. If international trade collapses due to aggressive tariff policies, this crucial source of financing also dries up.

The logical result? Treasury yields will skyrocket as the U.S. government is forced to rely more heavily on domestic financing to cover its deficits.

Trump’s insistence on lower interest rates—if imposed through pressure on the Federal Reserve—would be akin to trying to plug a financial dam with duct tape.

If the Fed attempts to suppress market-driven interest rate increases while international financing dwindles, the likely outcomes are clear: the dollar collapses, inflation surges, and U.S. financial markets spiral into chaos.

This is exactly what we saw unfold in Turkey. Erdogan’s obsession with low interest rates, combined with economic policies that defied market fundamentals, triggered a collapse of the lira, runaway inflation, and rising interest rates—the very opposite of what he intended. Trump’s plan risks steering the U.S. economy into a similar maelstrom.

No more rate cuts

As I’ve noted before, there is simply no room left for rate cuts in the current environment (see here and here).

The Federal Reserve has already undertaken a significant rate-cutting cycle, and further easing would risk fueling inflationary pressures. What’s more, the more President Trump talks about tariffs, the more likely it becomes that the Fed will have to hike rates rather than cut them.

Protectionist trade policies introduce inflationary risks.

Markets are already reacting to this reality, with Treasury yields edging higher whenever Trump reiterates his tariff agenda. Should these pressures persist, the Fed’s hand may be forced into tightening monetary policy to contain inflation, despite political pressure to do the opposite.

The Illusion of Control

It’s worth noting that the Federal Reserve, led by Jerome Powell, has consistently emphasized the importance of its independence from political pressure. The Fed’s mandate is to manage inflation and employment, not to cater to the whims of any administration.

While Trump may nominate Fed governors, he does not have statutory authority to dictate monetary policy. And this separation is vital to maintaining market stability.

Yet Trump’s rhetoric—“Interest rates should follow us all over the world”—reflects a fundamental misunderstanding of how global markets operate. The Fed’s role is not to lead a synchronized global rate cut. Each country’s monetary policy is shaped by domestic economic conditions. Forcing the Fed’s hand in this manner risks eroding its credibility, which could have long-term consequences for market stability.

Inflation’s Role in the Equation

Ironically, Trump has criticized inflation under his predecessor, yet his proposed policies could reignite inflationary pressures. By attempting to artificially suppress interest rates while tariffs drive up import costs, he risks a surge in consumer prices.

Inflation, far from being “transitory,” could become entrenched, forcing the Fed to implement even more aggressive rate hikes in the future. This is a lose-lose scenario for American consumers and businesses.

A Worrying Parallel

The parallels between Trump’s proposals and the dynamics of the 1970s are troubling. When political pressure overrides sound economic decision-making, inflation risks not only increase but can become deeply embedded. Even small missteps in this environment could have dramatic consequences.

The real solution lies in fostering open trade, ensuring fiscal discipline, and allowing the Federal Reserve to operate independently. Protectionism and monetary manipulation may offer short-term political wins, but they come at the expense of long-term economic health.

If there’s one lesson we can draw from Turkey’s experience, it’s that markets have a way of reasserting themselves, often in painful ways. Let’s hope policymakers in the U.S. take note before it’s too late.

A Record-Breaking January Jump

Last Friday, we got the January Manufacturing Business Outlook Survey from the Philadelphia Fed, and to say the numbers were eye-popping would be an understatement. The data, collected from January 6 to January 13, showed such a remarkable turnaround in manufacturing activity that it demands closer scrutiny – particularly given the political context we’re operating in.

Let’s dive into the numbers first. The headline index for general activity (“current activity”) skyrocketed from -10.9 in December to 44.3 in January – marking the largest monthly increase since June 2020 and reaching its highest level since April 2021. To put this in perspective, nearly 51% of firms reported increases in activity (up dramatically from just 19% last month), while only 7% reported decreases (down from 30%). The rest – 41% – reported no change.

Broad-Based Strength Across Indicators

The survey showed broad-based strength across multiple indicators:

• New orders surged by 47 points to 42.9, hitting levels not seen since November 2021
• Shipments rose 39 points to 41.0, reaching their highest mark since October 2020
• The employment index increased by 7 points to 11.9, with 87% of firms maintaining stable employment levels
• The average workweek index turned positive, jumping to 20.3 – its highest reading since March 2022

The Trump Effect or Something Else?

Now, here’s where things get interesting. The conventional wisdom might suggest this is a manifestation of “Trump optimism” – a business confidence boost following recent political developments.

However, I’m not entirely convinced by this explanation. The timing feels off – why didn’t we see any of this enthusiasm in the December numbers, when the political situation was already clear?

Instead, I suspect we’re seeing something more pragmatic at work: tariff anticipation. With Trump’s well-documented plans for massive increases in tariff rates, American manufacturing companies appear to be preparing for a very different trade environment.

If you’re a manufacturer using components from Canada, Mexico, China, or Europe, and you know these inputs might soon face significant tariffs, the logical move would be to stock up now, before the tariffs kick in.

Price Pressures and Future Expectations

The price data adds another layer to this story. Both price indices have risen above their long-run averages:

• The prices paid index increased to 31.9 (highest since December 2022)
• The prices received index jumped dramatically by 24 points to 29.7 (highest since January 2023)
• 36% of firms reported increases in input prices
• 35% reported raising their own prices (up sharply from just 9% last month)

The survey’s special questions about cost expectations for 2025 are particularly telling. While firms expect smaller cost increases for 2025 compared to 2024, they ranked demand for their goods/services as the most important factor in setting prices, followed by maintaining steady profit margins and labor costs.

Looking ahead, the future indicators paint an intriguing picture. The future activity index rose to 46.3, with 54% of firms expecting increased activity over the next six months. The future new orders index climbed to 57.3, and the future shipments index hit 60.2 – its highest reading since July 2021. The future employment index reached 40.4, suggesting continued hiring plans.

A Fed Policy Dilemma in the Making

For the Federal Reserve, this creates a particularly thorny problem. The combination of strong current activity, rising prices, and healthy employment would typically argue for maintaining tight monetary policy. But if this surge in activity is largely driven by tariff anticipation, it could prove temporary – potentially followed by a significant slowdown once new trade barriers are implemented.

The Bottom Line: Don’t Get Too Excited Yet

All things considered, while these numbers are impressive, they may be more a reflection of businesses adapting to potential policy changes than a signal of sustainable economic acceleration.

American businesses appear to be taking a “better safe than sorry” approach – building inventories and making preparations now rather than facing higher costs later. And given the stakes involved, who can blame them?

If I’m right about this interpretation, we should expect to see similar patterns in other U.S. economic data in the coming months – not so much in terms of future optimism, but in current activity levels and especially inventory building. And when the tariffs are actually implemented, we might see a corresponding or even larger dip in activity.

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.

The idea that central banks should conduct “climate policy” is fortunately dying out.

I say fortunately because central banks essentially have only one instrument – how much money they create – and that instrument can only be used for one thing.

So if one invents all sorts of tasks, one sets aside the main task – ensuring nominal stability.

The Federal Reserve understands this well, and yesterday the Fed announced that it has withdrawn from the “Network of Central Banks and Supervisors for Greening the Financial System”, while both the European Central Bank and other European central banks remain committed members of this network.

Over the last 10-15 years, we have seen a massive politicisation of the global financial system, where political decision-makers have put pressure both directly and indirectly on banks, pension funds – and indeed central banks – to “save the world” with all manner of agendas.

This has typically been about “climate”, “diversity”, “inclusion” etc. One can think what one likes about these objectives, but they all have in common that if one believes these things should be promoted, then one must do it through state subsidies or the opposite (taxes) and not through a politicisation of financial institutions.

As is known, I am not exactly a fan of Trump, but I thoroughly welcome that we are getting a reckoning with an entirely untimely politicisation of financial institutions – from commercial banks to central banks.

However, I have one significant concern – namely that we are merely replacing one form of politicisation with a new form of politicisation. That is, we are moving from forced “wokeness” to forced “anti-wokeness”.

And yes, the worst imaginable form of politicisation of monetary policy we might soon see – when Trump will force the Fed to conduct very accommodative monetary policy.

But I have always perceived “greening” of the financial system and central banks as an absolutely foolish idea.

And won’t we likely see a number of not only American, but also European banks and pension funds dramatically scale back their ESG, climate, DEI, etc. initiatives in the coming time?

A slightly nervous look at America’s financial future

The Story So Far: Everything is Fine(ish)

In recent days, I have been asked to write about public debt in the USA. So here we go…

If we start by looking at the development of the public finance deficit, we can see from the first graph that there has been an almost consistent deficit in US public finances – with the exception of a period in the late 1990s during Bill Clinton’s presidency.

The Numbers That Keep Me Awake at Night

It is also noteworthy that the deficit has simply grown larger year after year – even in a period like now, when the economy is growing quite strongly, unemployment is close to its lowest levels ever, and American stock markets are close to all-time highs.

The ongoing and increasing deficits are clearly reflected in the public (gross) debt, which has risen from about 40% of GDP 50 years ago to now a full 120% of GDP. For comparison, public debt in Denmark is around 30% of GDP.

The Good Old Days: When Interest Rates Were Your Friend

Despite the rising public debt, US government bond yields have generally been falling since the early 1980s. At that time, the 10-year government bond yield was 14% (nominal), but it steadily declined until 2020, when we reached as low as half a percent.

When interest rates are as low as they were leading up to 2020, it becomes very easy to take on debt. This is evident in the figures for US government interest expenses.

Interest expenses as a share of GDP reached around 5% of GDP in the early 1980s. However, the temporary stabilisation of government debt under Clinton and the falling interest rate levels meant that interest expenses as a share of GDP fell very sharply during the 2000s and up to 2020. This was despite the rising public debt.

In other words – American politicians were not punished for their irresponsibility.

The Global Financial Dance: It Takes Two to Tango

One might ask oneself why this didn’t happen? And the simple answer is globalisation.

In 1989, the Berlin Wall fell, and in 2001, China joined the World Trade Organisation (WTO). These events were a massive boost to global trade, and it also meant that there were more and larger buyers of US government bonds.

Over the past 30 years, China has thus built up an enormous foreign exchange reserve – and that reserve is filled with US dollars. And US government bonds. And the same story applies to other Emerging Markets.

When the Music Stops: China’s Exit from the Dance Floor

But that story has now turned. China is in crisis – and the country is no longer accumulating a growing foreign exchange reserve. On the contrary. And the same applies elsewhere in the world. Public finance problems are, for example, growing in Europe.

Thus, the demand for US government bonds is suddenly no longer structurally growing, but rather declining.

And this problem becomes significantly larger if Trump insists that US trade deficits with the rest of the world must be reduced. Because the trade deficit is the other side of the coin.

If someone is to buy US government debt, they must, so to speak, have a surplus to buy from. If there is no surplus, then there is also no demand for US government bonds.

Trump’s Greatest Hits: The External Revenue Service Edition

And even worse – within the last few days, Trump has announced that he will replace the Internal Revenue Service (IRS) with an External Revenue Service. In other words – he is more or less saying that he will replace all taxes and duties in the USA with taxation of foreign products – and perhaps duties on international capital movements.

This is an absolutely insane idea – if you have to raise tariffs as much as would be needed to, for example, abolish the federal American income tax, it would in practice mean that there would be no imports at all – and then we’re back to square one, because then there would be no revenue. And yes, then the public debt would truly explode.

It should also be noted that Trump has shown no interest whatsoever in doing anything about US government debt.

The Department of Magical Thinking

And yes, he talks about a Department of Government Efficiency (DOGE) that under Elon Musk’s leadership will find huge savings, but when you look at it, it’s extremely vague, and Trump has simultaneously said that he will under no circumstances touch the major fixed expenses such as Social Security and defence spending.

And now government bond yields have started to rise quite dangerously, and if we project the US government’s interest expenses as a share of GDP, we will soon hit 5% of GDP.

This also means that interest expenses will become an increasingly dominant part of US public spending.

The Demographic Plot Twist

Finally, it doesn’t exactly help the equation that Trump wants to throw hundreds of thousands of immigrants out of the USA.

This could potentially disrupt the otherwise positive demographic outlook for the USA and thus contribute to making the debt problem even larger.

The Trust Fall: When Bond Markets Get Nervous

So far, panic hasn’t really set in in the bond market, but I must admit that although I have previously been relatively calm about US fiscal policy, I must say that Trump is now really playing with fire, and it’s worth remembering that bond market pricing is largely built on trust.

And if that trust disappears, things can get very intense very quickly. And then US government bond yields will shoot up dramatically.

The Last Resort: When All Else Fails, Call the Fed

If that happens, the USA will rapidly move towards a situation where it won’t be able to repay its debt. And then there’s only one option left – call the Federal Reserve. In that situation, the Fed will be forced to buy government bonds to keep interest rates down. If that happens, the dollar collapses. And yes, inflation will explode.

The Not-So-Comforting Conclusion

I should emphasise that we’re not there yet, but I must say that when I hear Trump speak, he increasingly sounds like Turkey’s President Erdogan (or actually worse). And so far, the market has probably interpreted it as though once Trump becomes president, he will stop all this noise. But will he?

I’m no longer so sure.

Note: Yeah, that’s me in an AI created illustration done with fal.ai/FLUX.

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.

The Return of Inflation Fears

US inflation fears are back. Therefore, I have decided to revisit and update my favorite inflation forecasting model for the US – the P-star model.

In my recent post “Eeny, Meeny, Miny… Panic?”, I warned that markets are too optimistic about Fed rate cuts, with the (Theoretical) Mankiw Rule suggesting rates are already too low relative to fundamentals.

With M2 growth accelerating and inflation expectations rising, it’s time to examine what the P-star model tells us about inflation risks.

The model proved remarkably prescient in predicting the 2021-23 inflation surge when most observers, including the Federal Reserve, viewed inflation risks as “transitory.”

In April 2021 I correctly warned based on the P-star framework of an coming sharp spike in US inflation in my post Heading for double-digit US inflation.

Now, as markets again priced for further rate cuts for 2025 despite rising money supply growth and rising inflation expectations, the P-star framework may offer crucial insights about the inflation risks ahead.

However, today’s situation differs from 2021 in important ways.

While monetary growth is accelerating, we start from a position of normalized velocity and much higher interest rates.

The key question is whether the Fed can maintain its post-2021 monetary discipline in the face of both market expectations for easing and mounting political pressure.

The P-star Model – A Monetary Approach to Inflation

The P-star model, introduced by Hallman, Porter, and Small in their seminal 1989 Federal Reserve paper, provides a framework for understanding inflation through monetary dynamics.

The model builds directly on the Equation of Exchange:

MV = PY

Where: M is the money supply (typically M2) V is the velocity of money P is the price level Y is real GDP

The key insight is that there exists an equilibrium price level (P*) determined by the money supply (M), the long-run equilibrium velocity of money (V*), and potential output (Y*):

Starting from MV = PY, and assuming V = V* and Y = Y*, we get:

P* = MV*/Y*

Where V* is calculated using an HP filter (λ=1600 for quarterly data) to smooth actual velocity, and Y* is the Congressional Budget Office’s estimate of potential real GDP.

The gap between actual prices (P) and the equilibrium price level (P*) – what I call the P-gap – provides a powerful indicator of future inflationary or deflationary pressures:

P-gap = (P* – P)/P*

A positive P-gap indicates prices need to increase to reach equilibrium, signaling inflationary pressures ahead. A negative P-gap suggests prices need to decline to reach equilibrium, warning of deflationary pressures.

This framework captures a fundamental monetary truth: sustained inflation requires monetary accommodation.

While supply shocks and other factors can cause temporary price pressures, persistent inflation occurs when excess money creation allows these pressures to become embedded in the price level.

From 2021 Warning to Current Signals

In early 2021, the P-star model flashed a clear warning signal. Following unprecedented monetary expansion during the pandemic, the P-gap had turned sharply negative, indicating substantial inflationary pressures building in the system.

With M2 having grown by over 40% in just two years and velocity certain to normalize as the economy reopened, the model predicted significant inflation ahead – a prediction that proved remarkably accurate.

Today’s situation is more nuanced. The Fed’s cycle has helped close much of the inflationary gap that existed in 2021-22.

However, recent data suggests new pressures may be building. With M2 growth accelerating, our latest P-star calculations indicate the P-gap will start turning positive again in coming quarters unless the Fed maintains tight policy.

The key difference from 2021 is that we start from a position of normalized velocity and much higher interest rates. This means the immediate inflation risk is lower than in 2021.

However, continued M2 acceleration combined with already normalized velocity could quickly recreate inflationary pressures.

Our model suggests that while immediate inflation risks remain contained, the margin for Fed error has significantly narrowed.

With velocity normalized and M2 growth picking up, any premature easing could quickly reignite inflationary pressures. This creates a challenging backdrop for the Fed as markets price in continued rate cuts and political pressure for easier policy mounts.

The question now becomes whether Powell’s Fed will maintain its post-2021 discipline or risk repeating past mistakes. To answer this, we need to examine how monetary policy transmission varies across different regimes.

Regime Changes Matter – From Great Moderation to Great Anxiety

To understand current risks, we need to examine how monetary transmission varies across different policy regimes. Our regression analysis of the P-gap’s impact on inflation reveals a striking pattern across monetary history.

The graph below shows the regime-dummies for the coefficient of the P-gap in an inflation regression.

This essentially shows how strong the pass-through is from excessive money supply growth to inflation and that this clearly is regime dependent.

During periods of well-defined monetary rules – e.g. during the Bretton Woods period or the inflation targeting period – the pass-through is weaker than during periods of low credibility. This was the case in the 1970s, but was also the case during the monetary expansion in 2020-2022.

The strength of monetary transmission tends to increase during periods of fiscal dominance and regime uncertainty. This pattern makes the current Trump/Powell dynamic particularly concerning, as it echoes aspects of the Nixon/Burns era when monetary policy became subservient to fiscal priorities.

Initially, I believed we had returned to Great Moderation-style credibility. Bond markets still suggest this, with breakeven inflation rates relatively stable. However, three developments challenge this optimistic view:

First, consumer inflation expectations have jumped from 2.8% to 3.3% between November 2024 and January 2025. Unlike market-based measures, consumer expectations appear more sensitive to announced policy changes.

Second, Trump’s increasingly aggressive tariff proposals echo the supply-side shocks that complicated monetary policy in the 1970s. Nearly one-third of consumers now spontaneously mention tariffs as an inflation concern.

Third, our regression analysis shows monetary transmission has strengthened significantly (coefficient 0.24), suggesting policy mistakes could have larger effects than during the Great Moderation period.

These factors create an environment eerily reminiscent of the early 1970s, when policy credibility began eroding before markets fully recognized the regime change. The question now is whether Powell will maintain his post-2021 Volcker-like resolve or succumb to political pressure like Burns.

The stakes may be even higher today given larger debt levels and more integrated global financial markets. This brings us to the crucial question of fiscal versus monetary dominance.

The Looming Threat of Fiscal Dominance

The real risk to price stability may not come from monetary policy directly, but from a potential crisis of confidence in U.S. fiscal sustainability. The incoming administration’s proposal to eliminate federal income taxes in favor of tariff revenue (yes, Trump has indeed suggested this) creates a particularly dangerous dynamic in current monetary conditions.

Consider the potential chain reaction: Markets begin questioning the revenue adequacy of this fiscal shift, pushing bond yields higher. Rising yields increase debt service costs, worsening fiscal dynamics.

This could trigger a negative feedback loop where fiscal concerns drive yields higher, further straining government finances.

Under normal circumstances, such concerns might force fiscal adjustment. However, the combination of strong monetary transmission (P-gap coefficient 0.24), normalized velocity, and rising inflation expectations creates a precarious situation.

Any hint that the Fed might cap yields through renewed QE could trigger a rapid shift in inflation expectations.

The risk scenario isn’t just about fiscal deficits – markets have tolerated large deficits before. The key danger is a sudden loss of confidence in the eventual normalization of U.S. fiscal policy.

If investors begin questioning whether there’s any path to fiscal sustainability, the pressure on monetary policy could become intense.

Unlike the 1970s or even 2021, today’s globally integrated bond markets could amplify any loss of confidence. With foreign investors holding significant U.S. debt, a shift in sentiment could trigger rapid portfolio adjustments, forcing the Fed to choose between defending price stability and maintaining financial stability.

This scenario would put Powell’s commitment to price stability under severe test – far more challenging than the inflation fight of 2022-23. The combination of fiscal dominance and strong monetary transmission could create inflation dynamics more powerful than anything seen since the 1970s.

Watch the P-gap, But Fear Regime Change

The updated P-star model does not, in itself, signal an imminent inflation surge like it did in 2021.

However, with M2 growth accelerating and velocity normalized, the P-gap projections suggest the Fed should be contemplating tighter, not looser, policy in the quarters ahead.

This technical conclusion puts the Fed on a collision course with both market expectations and political pressures.

While Powell has demonstrated more Volcker-like resolve since learning from his 2021 mistake, the real test may come from the bond market rather than direct political pressure.

The crucial risk is not just inflation itself, but a potential shift in market confidence about U.S. monetary-fiscal coordination. If investors begin questioning the long-term framework for price stability and fiscal sustainability, we could see a rapid shift from Great Moderation-style dynamics to something more reminiscent of the 1970s.

The current mix of:

• Strengthened monetary transmission
• Rising inflation expectations
• Tariff threats
• Radical fiscal proposals
• Normalized velocity

Creates an environment where policy mistakes could have outsized effects on inflation. While the P-star model suggests these pressures are still containable, the Fed has very little room for error.

Markets may be underestimating both the Fed’s resolve and the risks from fiscal-monetary interactions.

The lesson from 2021 was that monetary forces matter more than commonly assumed. The lesson from the 1970s was that once policy credibility erodes, regaining it becomes extremely costly.

Powell needs to thread a very narrow needle in 2025.

The P-star model suggests he should resist premature easing. History suggests he should fear regime change above all. Markets suggest he has a difficult job ahead.

As markets hang on every word from the Federal Reserve, a seismic shift in monetary policy could be just around the corner—and I don’t think investors are fully ready for this – yet.

While Wall Street continues to bet on further rate cuts, the data tells a different story. Inflationary pressures are rising, consumer expectations are shifting, and the Fed is quietly signaling that the era of rate cuts is over.

This pivot could catch markets off guard, triggering a major stock market correction.

Revisiting the Mankiw Rule: Why It’s Still Relevant Today

The Mankiw Rule has long been used as a reliable guide to predict Federal Reserve policy. I have earlier written about the Mankiw Rule and suggested an improve version which I have termed the Theoretical Mankiw Rule. This my post “Eeny, Meeny, Miny, Mankiw: The Surprisingly Accurate Way to Guess Fed Policy” from July 2024 here.

The formula is straightforward but powerful:

This framework captures the core elements of the Fed’s dual mandate: inflation and unemployment. By applying recent data, it becomes clear that the Fed has little room to ease policy further without risking runaway inflation.

The graph below shows the updated Theoretical Mankiw Rule with the latest data included. I have furthermore conducted a simulation for interest rates for the remainder of 2025, where I assume that inflation will decline to 2.5% from the present 2.8%, and unemployment will increase to 4.5% from the present 4.1%.

Both of these assumptions actually mean LOWER rates, but the problem is that we will still have too high inflation relative to the Fed’s 2% target, and that interest rates presently are too low compared to the Theoretical Mankiw Rule.

Furthermore, there are good reason to believe that this is far too conservative assumptions. Inflation could very well spike a lot more on Trump’s planned tariffs and there are in my view signs that the natural interest rate now is being pushed up – for example by increased defense spending in Europe, geopolitical concerns and the fact that the Trump administration are unlikely to deliver on fiscal consolidation.

In fact this mean that the Fed should maintain or even increase rates in response to rising inflation and a resilient labour market.

Inflation Expectations Are Rising Rapidly

One of the most concerning developments is the surge in consumer inflation expectations. According to the University of Michigan’s latest survey, inflation expectations for the coming year have jumped from 2.8% in November 2024 to 3.3% in January 2025.

This rise in expectations is not happening in a vacuum. Tariff concerns have been a major driver of inflation anxiety. As the University of Michigan pointed out:

“Nearly one-third of consumers spontaneously mentioned tariffs as a concern, up from 24% in December and less than 2% prior to the election.”

Consumers worry that these tariffs will push prices higher, and their concerns are now reflected in inflation expectations. This is a critical data point that the Fed cannot ignore, and it raises the risk that the central bank will need to tighten policy sooner rather than later.

Tariffs, Inflation, and Trouble Ahead: The Fed’s New Reality

The rise in inflation expectations comes against a backdrop of Trump’s tariff policies, which continue to create uncertainty in global trade. These tariffs are effectively a tax on consumers and businesses, driving up the cost of goods and services.

The Fed’s latest FOMC minutes show that policymakers are increasingly concerned about these upside inflation risks:

“Almost all participants judged that upside risks to the inflation outlook had increased.”

This shift in tone suggests that the Fed is moving closer to pausing rate cuts and may even consider rate hikes if inflation continues to surprise to the upside.

The Market Disconnect: Why Wall Street Isn’t Ready

Wall Street remains overly optimistic about further rate cuts. The disconnect between market expectations and the Fed’s outlook is stark. Equity markets are priced for perfection, with valuations near historic highs. But if the Fed shifts gears and starts to tighten policy, those valuations could come crashing down.

Here’s why:

• Rising inflation expectations mean the Fed has less room to cut rates.
• The Fed’s neutral rate is higher than markets expect, suggesting that the current rate is already close to where it needs to be.
• Tariffs and fiscal policies are creating inflationary pressures that the Fed must address.

In other words, the market is betting on a scenario that the Fed itself is not endorsing. This disconnect could result in a painful market correction if investors are forced to adjust their expectations.

From Easing to Squeezing: The Fed’s Next Pivot Could Bring Pain

The Fed’s pivot from easing to tightening will likely be gradual, but the market impact could be sudden. If inflation continues to surprise to the upside, the Fed will have no choice but to tighten monetary policy faster than markets anticipate.

This is where the Theoretical Mankiw Rule becomes particularly useful. My updated calculations show that the Fed funds rate should remain stable or even rise over the next two years to keep inflation in check. Yet markets are still pricing in rate cuts, creating a dangerous mismatch.

Eeny, Meeny, Miny… Panic? The Market May Not Be Ready for What Comes Next

The current state of US equity markets is concerning. Almost every valuation metric suggests that stocks are expensive.

The S&P 500 is trading at levels that assume a continued easing of monetary policy. But what if that easing doesn’t come?

The most likely trigger for a correction is a renewed focus on inflation and the Fed’s response to it. If inflation picks up faster than expected and the Fed is forced to act, we could see a 10-20% drop in the S&P 500 over the next 3-6 months.

Investors should brace for volatility. The Fed’s pivot is coming, and the market is not prepared. When the realization hits, panic could set in.

Conclusion: No More Cuts, But Plenty of Bruises

There are clear signs that the Fed is done with rate cuts. Inflation data, consumer expectations, and the Fed’s own communications all point to a shift in policy. Markets, however, continue to price in further easing, creating a dangerous disconnect.

The risk of a significant correction in US equities has increased. As inflationary pressures mount and the Fed pivots from easing to tightening, investors should prepare for bruises. The era of easy money is ending—and the market’s not ready.

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.