Yesterday, the Trump administration announced new tariffs of 25% on all imports from Mexico and Canada and 10% on all imports from China. In response to this announcement – which wasn’t entirely unexpected – US stocks fell and interest rates rose.
The simple interpretation is that higher import prices drive up US inflation, causing the Federal Reserve to raise the policy rate (pushing market rates up). This reduces economic activity (and therefore earnings in US companies, hence pushing stocks down).
While there’s certainly truth to this, it should be noted that firstly, an import tariff is a “one-off” increase in price level, and the resulting rise in inflation is only temporary – in a year, inflation will fall back (though the price level will remain higher). And the Fed shouldn’t really react to this.
The real story: America’s monetary superpower status at risk
However, in my view, there’s a more important mechanism at play that leads to PERMANENTLY higher rates if the tariffs are maintained. For decades, the US has enjoyed what’s known as an “exorbitant privilege” – a term coined by French finance minister Valéry Giscard d’Estaing in the 1960s when he was serving under President Charles de Gaulle.
He used this phrase to describe what he saw as America’s unfair advantage of having the dollar as the world’s reserve currency.
As American economist Barry Eichengreen later perfectly summarized: “It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries had to pony up $100 of actual goods in order to obtain one.”
This privilege has allowed the US to run persistent deficits in both its balance of payments and trade balance – importing more goods and services than it exports. The flip side of this is capital movements. The deficit means that the US has EXPORTED dollars (that’s what the deficit is paid with), and as the global reserve currency, these dollars are eagerly absorbed by foreign central banks and investors.
This “exorbitant privilege” means that China, for instance, has built up large foreign exchange reserves over the past 30 years.
These reserves are largely held in dollars – and dollar assets – such as US Treasury bonds and money market papers. This naturally means that the interest rate on these papers is LOWER than it would otherwise have been. Moreover, strong international demand for dollars means that the US can print more money without it becoming inflationary – essentially getting a “free lunch” from its reserve currency status.
Therefore, if Trump truly wants to significantly reduce the US balance of payments and trade deficit through increased tariffs, he may inadvertently kill this “exorbitant privilege.”
It will mean less EXPORT of dollars – and yes, this must, ceteris paribus, lead to higher US interest rates (both real and nominal) and increased inflationary pressure – not primarily due to higher import prices, but simply because there will be less global dollar demand (less money demand).
Crucially, these dynamics imply a higher so-called natural rate of interest. This means the Federal Reserve would HAVE to raise rates just to maintain a neutral monetary policy stance – regardless of any direct inflationary effects from the tariffs themselves. The alternative would be effectively running an expansionary monetary policy at a time when the economy’s natural interest rate has risen – a recipe for additional inflationary pressures.
All of this is probably too complicated for Donald Trump to understand, but markets can easily see it… and if Trump continues down this path, we might as well get used to falling stock prices and significantly higher interest rates as America’s “exorbitant privilege” begins to erode. And then it will suddenly be very, very hard to fund the US government budget deficit.
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.
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.
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.
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.
Over the past 24 hours, a remarkable confrontation has unfolded on X (formerly Twitter) that perfectly encapsulates the inherent contradictions in Elon Musk’s political positioning and the broader tensions within American tech politics.
The drama began when Musk, the owner of X and Tesla CEO, launched into an expletive-laden defence of the H1B visa programme, declaring “The reason I’m in America along with so many critical people who built SpaceX, Tesla and hundreds of other companies that made America strong is because of H1B.”
When challenged by MAGA supporters, Musk’s response escalated dramatically: “Take a big step back and FUCK YOURSELF in the face. I will go to war on this issue the likes of which you cannot possibly comprehend.”
The reaction from MAGA figures was swift and severe. Laura Loomer, a prominent voice in the movement, immediately countered: “We have an incoming President and his name is Donald Trump… We won’t allow Big Tech to create their fantasy monarchy in America and make MAGA their indentured servants slaves.”
The confrontation intensified when Musk attempted to use his platform control to mark critics’ posts as “spam” – a move Loomer immediately characterised as “totalitarian conduct by an incoming admin official.”
This exchange lays bare not only the fundamental contradictions in Musk’s position but also serves as a perfect case study for understanding the evolution of rent-seeking behaviour in the modern technological age.
Modern Rent-Seeking Through Tullock’s Lens
What we’re witnessing with Elon Musk’s business empire represents precisely the kind of rent-seeking behaviour Gordon Tullock warned about in his seminal 1967 work on the welfare costs of tariffs, monopolies, and theft.
Tullock’s central insight was that the social costs of rent-seeking vastly exceed the nominal value of the rents themselves, as resources are expended not just in securing preferential treatment but in creating and maintaining the institutional frameworks that make such treatment possible.
The proposed Strategic Bitcoin Reserve perfectly illustrates Tullock’s principle.
When Tesla entered the Bitcoin market in late 2020, triggering a price surge to $63,000 in 2021, it wasn’t merely engaging in financial speculation. Rather, it was positioning itself for what would become a sophisticated form of rent extraction through potential government policy.
The correlation between Tesla’s stock price and Bitcoin since then shows remarkable synchronisation, suggesting that the market understands this connection between private gain and public policy.
Stigler’s Regulatory Capture in the Digital Age
George Stigler’s theory of economic regulation provides the perfect framework for understanding Musk’s approach to government interaction. Stigler argued that regulatory capture occurs when regulatory agencies, created to act in the public interest, instead advance the commercial or special interests of the entities they are meant to regulate.
In Musk’s case, this manifests through a complex web of subsidies, regulatory credits, and government contracts.
The implications for taxpayers worldwide are staggering. American taxpayers fund SpaceX contracts and EV subsidies. European taxpayers, particularly German citizens, fund factory subsidies and EV incentives.
Now US taxpayers might effectively fund Bitcoin price support through the proposed Strategic Bitcoin Reserve.
What makes Musk’s case particularly interesting is how he has managed to secure these benefits while simultaneously maintaining a public image as a free-market innovator.
This is precisely the kind of sophisticated regulatory capture that Stigler warned about – where the line between regulator and regulated becomes so blurred that the public can no longer distinguish between market success and political favoritism.
The Collision of Rent-Seeking and Populism
The sophistication of Musk’s rent-seeking strategy is now colliding spectacularly with political reality.
The confrontation on X over immigration reveals how the careful balance of maintaining political influence while extracting government benefits can suddenly unravel.
As Tullock observed, the resources invested in securing and maintaining regulatory capture can quickly become stranded when political winds shift.
The China dimension adds another layer to this complexity. Musk’s recent statement that Taiwan is a natural part of China exposes not just his dependence on the Chinese Communist Party’s goodwill for Tesla’s Chinese production, but also the inherent instability of global rent-seeking arrangements.
As Loomer pointedly noted in today’s barrage of posts: “A lot of compromising news involving China dropped today… Tumultuous times are definitely upon us as it relates to China.”
This international dimension would have fascinated Tullock. His analysis of rent-seeking primarily focused on domestic arrangements, but Musk’s empire shows how modern corporations can extract rents across multiple jurisdictions simultaneously. The risk, as we’re now seeing, is that these arrangements become increasingly difficult to maintain as nationalist politics resurges.
The Social Costs Mount
The social costs of this rent-seeking behaviour, so central to Tullock’s analysis, are becoming increasingly apparent. Resources that could be directed toward genuine innovation are instead channeled into maintaining political relationships and regulatory advantages.
Tesla’s regulatory credits alone represent a massive transfer of wealth from traditional automakers (and ultimately their customers) to Tesla’s shareholders.
Stigler’s insights about regulatory capture help explain why these arrangements persist despite their obvious costs. The benefits are concentrated among a few well-organized interests, while the costs are diffused across the broader population. However, as today’s Twitter confrontation shows, even this dynamic can shift when populist movements mobilize against perceived elite privilege.
Markets at Risk
The current surge in tech stocks following Trump’s electoral success may prove to be built on dangerously naive assumptions.
Just as MAGA’s fundamental opposition to immigration and free trade has caught tech leaders like Musk off guard, the movement’s latent hostility to technological advancement – particularly AI and automation – presents a serious threat to market valuations.
Trump’s recent meeting with the International Longshoremen’s Association, where he strongly criticised port automation, provides a troubling preview of what might come.
His economic thinking increasingly resembles that of a 1970s New York union leader more than a free-market Republican.
This philosophy, fundamentally opposed to the forces that drive productivity growth – whether they come in the form of immigration, trade, or technological advancement – poses a direct threat to the tech sector’s growth narrative.
The End Game
The world Tullock and Stigler described – where corporations invest resources to capture government benefits – has evolved into something far more complex but no less wasteful.
The confrontation on X between Musk and MAGA supporters isn’t just another social media spat – it’s a preview of how quickly carefully constructed rent-seeking arrangements can unravel when confronted with populist politics.
For tech companies like Tesla, which have benefited from both government subsidies and market optimism about technological disruption, this presents a perfect storm.
The same populist forces that are now turning against Musk over immigration could easily pivot to attack AI and automation.
The tech elite’s fundamental miscalculation extends beyond immediate political dynamics. Their naive belief that they could harness MAGA populism while avoiding its anti-modernisation impulses may prove to be an extremely costly miscalculation.
The profound irony is that while Trump claims to put “AMERICA FIRST”, his opposition to automation and technological advancement could ultimately leave American tech companies – and by extension, the broader American economy – at a competitive disadvantage in the global marketplace.
This outcome would represent exactly the kind of deadweight loss that Tullock warned about – where rent-seeking behaviour ultimately damages both the rent-seekers and the broader economy.
As we watch this situation unfold, the prescience of both Tullock and Stigler becomes increasingly apparent. Their fundamental insights about the nature of rent-seeking and regulatory capture remain as relevant as ever. The only difference is that modern rent-seeking has become more sophisticated, more global, and more technologically complex – but its essential nature, and its fundamental instability, remains unchanged.
I have increasingly become frustrated by the focus on “overheating” of the Russian economy championed by many Western military and geopolitical analysts.
The narrative more or less goes something like this: fiscal policy is very easy in Russia, so demand is high, and therefore there are now massive demand pressures, which cause ‘overheating’ and will lead to a collapse of the Russian economy soon. This is essentially a ‘boom-bust’ story.
The problem is that such a story aligns very badly with economic theory—or, for that matter, economic history. Economies don’t ‘collapse’ because of overheating.
Sudden economic collapses typically happen as a result of a major negative demand shock—typically monetary tightening, either caused by active monetary tightening by the central bank or caused by passive monetary tightening due to a financial crisis.
Russia might, of course, be hit by that, but that is not really the story being told by the military analysts who so very clearly have no economic education at all.
Furthermore, the focus on ‘overheating’ fails to address two much more important issues for the Russian economy: the structural decline in economic growth caused by Putin’s war on Ukraine, and the fact that the large Russian government budget deficit is clearly unsustainable and is de facto causing a major monetary expansion that is set to get even worse going forward.
To understand these issues, I have created a simple model for the Russian economy inspired by the seminal work of Sargent and Wallace on “Unpleasant Monetarist Arithmetic.” The model illustrates how fiscal and monetary factors have shaped Russia’s economic development since Putin started his war on Ukraine in February 2022, revealing that the apparent resilience of the economy is largely an illusion created by monetary manipulation.
Additionally, we will examine the evolving role of the Central Bank of Russia (CBR), which has transitioned from a conservative institution to one effectively subordinated to the Kremlin’s fiscal agenda. Contrary to the common conception, the Russian central bank is not an inflation fighter. It is effectively Putin’s lapdog.
The Model
Below are the equations in this simple model for the Russian economy. First, we focus on the supply side of the economy with a traditional Cobb-Douglas production function.
(1) yt* = at + αkt + (1 − α)lt
Where yt* is the growth rate of potential GDP in Russia, at is total factor productivity growth, kt is the growth rate of capital and lt is the growth rate of the labour supply.
Equation (2) determines the growth rate of the money supply mt:
(2) mt = m̄ + dt
m̄ is the ‘structural’ growth rate of the money supply. Think of this as being determined by the financial system and the central bank, while dt is the government budget deficit, which we here assume de facto is fully financed by an increase in the money supply.
Equation (3) determines long-term inflation (πtᶫ) as a pure monetary phenomenon:
(3) πtᶫ = mt − yt*
If the money supply growth (mt) persistently outpaces potential gdp growth (yt*) then inflation will eventually increase.
However, in the short-run there are price rigidities and this is what is reflected in equation (4):
(4) πt = πt−1 + γ(πtᶫ − πt−1) + δŷt
Furthermore, we have a ‘Phillips curve’ effect on short-term inflation as a positive output gap (ŷt) also can push up inflation.
The fact that we have price rigidities also means that actual GDP growth can diverge from potential GDP in the short to medium term:
(5) yt = yt* + λ(πtᶫ − πt)
Hence, as long as long-term inflation is above short-term inflation then actual GDP growth will outpace potential GDP growth. Again, this is akin to the Expectations-Augmented Phillips Curve.
Equation (6) is (growth in) the output gap defined as the difference between actual gdp growth and potential gdp growth:
(6) ŷt = yt − yt*
Equation (7) is the natural real interest (rt) which is determined by a ‘structural’ level of the interest rate (for example dependent on global interest rates) and a factor that dependent on the budget deficit so a higher budget deficit as share of GDP increases the natural real interest rate.
(7) rt = r̄ + ηdt
Equation 8 is the nominal interest rate (it):
(8) it = rt + πt
The nominal interest rate is simply determined by the sum of the natural real interest rate and actual inflation.
One could (easily) have argued that we should have used the long-term inflation instead to reflect inflation expectations, but we have assumed for simplicity that expectations are static in the model.
This is obviously not realistic, but by comparing the short-term and long-term impact of shocks to the model, we can analyze these expectational effects indirectly nonetheless.
The Russian Economy Post-2022: A Simulation
I have used the model above to simulate two simultaneous shocks to the Russian economy triggered by Putin’s invasion of Ukraine in February 2022.
First of all, we have assumed a decline in total factor productivity growth, the genuine driver of long-term economic development.
In our model, total factor productivity (TFP) growth drops dramatically from an initial 3% to just 1%, reflecting the profound economic disruption caused by international sanctions, technological isolation, and the massive economic restructuring forced by the conflict.
Simultaneously, the model incorporates a second critical shock: a severe contraction in labour market dynamics. While the initial baseline assumed stable labour supply growth, the simulation shows labour supply growth turning negative, dropping from 0% to -1%.
This shock represents the complex human capital challenges Russia faced: widespread emigration of skilled professionals, military mobilization, and the broader economic dislocation triggered by the invasion.
The fiscal dimension of these shocks is equally dramatic. The model assumes a rapid escalation of budget deficits, rising from 0% to 10% of GDP between 2021 and 2023. This represents the massive state expenditures required to sustain a war economy, fund military operations, and attempt to mitigate the economic consequences of international isolation.
Obviously, one can debate the magnitude of these shocks and their speed, but I have chosen them to more or less reflect the scale of the shocks we have actually seen in Russia since February 2022. The graph below shows our stylised fiscal shock where we assume that the budget deficit increases from zero in 2021 to 10% of GDP in 2023.
One can debate the actual numbers, but the latest data from the Russian Ministry of Finance do in fact show a budget deficit of this magnitude by the end of 2023. I have chosen to implement the shock a bit faster than it really was, but that will, on the other hand, make up for the fact that we have assumed static expectations rather than forward-looking expectations.
In the model, we have full monetary financing of this deficit, and consequently, we see money supply growth increase significantly in response to the sharp increase in the budget deficit, as the graph below shows – basically doubling money supply growth from just below 10% to close to 20%.
Again, one can discuss the actual mechanism by which this happens – whether it is through actual money printing or whether it is a result of the Russian central bank failing to offset the monetary and expectational impact of an increased budget deficit – but the fact remains that this development broadly speaking reflects the growth rate in Russian M2.
In the years leading up to the invasion of Ukraine, Russian M2 grew around 8-10% a year, and since early 2022, M2 growth has been consistently above 20% and often higher.
The sharp increase in money supply growth in the model is clearly inflationary.
First, of all through a direct monetary effect that increases long-term inflation (and in reality inflation expectations) and secondly, through a Phillips curve effect that also push inflation up in the short-term.
We see this in the graph below.
Initially – prior to the invasion – Russian inflation was below 5%.
However, as the shock hit, we see long-term inflation (the dotted line above) increase. However, initially actual inflation will remain below the long-term inflation, as we have assumed price rigidities in our model.
Such rigidities exist, for example, due to fixed prices in certain contracts, but they could also reflect the widespread price controls that have been introduced in Russia since February 2022.
However, eventually prices will adjust to the long-term monetary-induced inflationary pressures and, furthermore, the Phillips curve effects combined with the negative supply shock will also add to inflationary pressures in the medium term.
In the model, inflation hits 15% during 2023 and nearly 17% in 2024.
If we compare these numbers with actual inflation, as shown in the graph below, we see that the development has been somewhat more uneven in real life, where we initially in 2022 saw a very sharp spike in inflation to close to 20%, followed by a rather steep drop mostly reflecting a base effect, and then recently a new increase.
The latest official data shows Russian inflation at close to 9%.
One could clearly question the validity of the inflation data in Russia and I personally find it highly likely that they are manipulated, but even if we assume that the numbers are correct, I would argue that the model simulations get it pretty right.
Hence, if we instead of looking at a single year look at the average inflation from the beginning of 2022 to the end of 2024, then it is fair to say inflation has been around 10-12% as an average over the period and is clearly showing signs of increasing further.
And this is of course exactly what we are seeing in the simulation – inflation from 10-15% in the 2022-24 period and a clear upward trend. Consequently, if we instead had compared the actual and predicted price level in Russia, it would in fact be rather close by the end of 2024.
So not only does it look like the model is more or less correct in explaining the increase in Russian inflation (and in the price level) – it is also pointing towards a relatively steep further increase in Russian inflation over the coming year.
And the reason this might be kicking in with more effect now is that we are likely to begin to see the effect of the negative supply shock and because we are moving closer to the ‘long-run’.
We get an illustration of that by looking at the simulations for the development of potential and actual GDP growth, as the graph below shows.
We see two things here.
First of all, we see actual GDP growth (the solid blue line) increase slightly initially as fiscal and monetary policy is eased, but secondly, we also see a sharp decline in potential GDP growth (the dotted line).
The sharp slowdown in potential GDP growth is the direct impact of capital flight, sanctions and an erosion of the labour force as men are mobilized to go to the front and others – maybe close to 1 million Russians – have escaped from the horrors of Putin’s war.
This will soon become the real drag on the Russian economy, as we clearly see in the graph where we should already have seen actual GDP start to converge towards the much lower potential GDP growth.
However, in reality we haven’t seen that effect fully emerge yet, and that is also why actual inflation now is below (around 9%) what our model predicts (15-17%) – at least if we trust the Russian statistics (which we should not).
But what about actual GDP growth? We see that in the graph below.
First of all, we see that before the war, actual GDP growth was in fact somewhat below potential GDP (which we initially assumed to be around 3%).
Furthermore, we also see that actual GDP growth contracted significantly in the early phase of the war.
Our simulations – on purpose – have not taken the initial negative demand shock into account as we are more interested in analysing the longer-term impact of the negative supply shocks and the fiscal-monetary nexus.
However, we do see that over the past 15-18 months, Russian GDP growth has been around 4%, more or less as predicted by the model.
We also see that we seem to have begun a slowdown in Russian GDP – from around 4.5% to just above 3% by the end of 2024.
It is certainly no collapse, but keeping in mind just how expansionary fiscal and monetary policy is, then this is notable and in line with the predictions from the simulation.
It therefore also just seems a matter of time before the real world catches up (or rather down!) to the model predictions.
What will cause actual GDP growth to converge (down) towards the much lower potential GDP growth will be what we could call an inflationary-induced tightening of monetary policy – or what in textbooks is often called a real-balance effect or a Pigou effect.
This effect kicks in once inflation starts to adjust to the higher money supply growth. Remember, we have in the model assumed that there are price rigidities, and this is certainly realistic in an economy like the Russian with widespread price controls.
Effectively, this means that at some point inflation will start to outpace money supply growth, and at that time, we will effectively get monetary TIGHTENING. Not because NOMINAL money supply slows, but because REAL money supply growth slows once inflation picks up for real.
We see this in the graph below where the ‘monetary gap’ is the difference between nominal money supply growth and inflation.
In the model, this effect should have started to kick in a year ago, but in reality, this is likely somewhat delayed even though we are actually at the moment seeing this starting to unfold.
Consequently, this ‘passive’ or ‘automatic’ tightening of monetary conditions is very likely to start to depress demand in the Russian economy relatively soon, and as a consequence, we could see actual GDP growth start to slow rather substantially.
This would undoubtedly lead the ‘overheating’ crowd to yell ‘I told you so’, but the fact is that this is not a bust caused by overheating, but rather the good vertical Phillips curve combined with the Pigou effect kicking in and pushing actual GDP growth down towards potential GDP growth that in the meantime has slowed substantially compared to before the war.
There is, however, also another scenario: a scenario where inflation is ‘contained’ by even more widespread and draconian price and wage controls in Russia, and given the regime’s more and more totalitarian and Soviet-style policies, this should not be a surprise.
However, in this scenario, we get the ‘bust’ in another form. What we should then expect to happen is that we don’t see open inflation, but rather ‘closed’ inflation, which means that goods simply disappear from the shelves in the supermarkets.
In this scenario, GDP growth contracts not because of lower demand, but because producers simply stop producing as it will no longer be profitable due to price controls. But that is not the scenario we simulate in the model. The model nonetheless educates us as to why such a scenario could become reality.
So now we have looked at inflation and real GDP growth, and we have shown that sooner or later, inflation will rise sharply if large budget deficits are funded by printing money. What we have in fact assumed is that the Russian central bank is not really independent and that it is the needs of Putin’s war machine that determine the growth rate of the money supply.
Elvira Nabiullina Is Just Another Servant of Putin
The Russian central bank governor Elvira Nabiullina has for years been seen in the financial markets as a guardian of price stability in Russia, and she is often described as ‘conservative’ or ‘ultra-orthodox’ in her monetary policy views and even as a ‘reformer’.
Frankly speaking, I used to use those terms about her, and the fact that she has hiked the CBR’s key policy rates repeatedly over the past year has led many observers to conclude that she is still a world-class central banker trying hard to secure price stability in Russia.
Even among the biggest critics of the Russian regime, it is hard to find anybody willing to be critical about Nabiullina’s conduct of monetary policy.
But this, in my view, is wrong, and it stems from a well-known fallacy in monetary analysis – the fallacy of concluding that ‘high’ and ‘increasing’ NOMINAL interest rates indicate a tight monetary policy, but as Milton Friedman taught us long ago – interest rates are HIGH when monetary policy has been EASY.
And this is in fact exactly what our simulations show us.
The graph below shows the development in nominal and real interest rates in the simulation.
It is important to notice that in the model, the central bank does not in fact CONTROL interest rates – at least not directly and certainly not in the way that many people (and even economists) believe central banks SET interest rates.
In the model, the natural real interest rate is determined by fiscal policy. If the government runs a large deficit, then the real interest rate will increase. And if we add inflation (or inflation expectations) to the real interest rates…
What we see in the simulation is that this ‘market’ determined nominal interest rate increases from around 7% before the ‘shocks’ to just above 21% in 2023 and further towards more than 25%.
This, however, is not ‘monetary tightening’ – it just reflects a large increase in the budget deficit that first of all increases natural real interest and secondly higher inflation due to higher money supply growth – also caused by the large budget deficit.
But let’s compare this with what Nabiullina has actually done with the key policy rate. The graph below shows this.
What do we see?
We start out around 7% and we are now at 21%. Nabiullina delivered the latest rate hike back in October.
If we compare this to our simulation – this is more or less the same, or rather we should have been at 25% rather than 21%. Looking at real interest rates, the difference is a bit smaller.
But what is the real story here?
The story is that Russian monetary policy in no way can be described as ‘TIGHT’ and there is nothing ‘prudent’ or ‘ultra-orthodox’ about how Nabiullina has conducted monetary policy, particularly over the past 12-18 months. She is barely keeping up with the increasing natural real interest rate and inflation expectations.
And there is another story here – is she getting ‘soft’? Or has Putin now fully taken over also in terms of monetary policy?
Back in 2022, she did in fact tighten monetary policy as we see in the graph above – the key policy rate was increased sharply and much more so than our simulations indicated it should. This is an indication that at that time Nabiullina actually had some monetary independence.
On the other hand, the rate ‘hikes’ over the past 12-18 months do not really show that – it simply shows that the CBR is ‘shadowing’ the market interest rates.
In fact, it might even be worse. Last week the CBR unexpectedly kept its key policy rate unchanged at 21% (a hike had been expected) and at the press conference following the rate decision the governor said:
“The decision to leave the rate at 21% was motivated by the fact that the data over the past six weeks, which describe both actual lending activity and the intention to grow loan portfolios further, demonstrate quite convincingly that it’s very possible that the required tightness in monetary conditions needed to slow inflation has already been achieved.”
And she might in fact be right – it is the Pigou effect that we mentioned above that might be starting to kick in. However, the monetary “tightening” is NOT a result of direct actions of the central banks as the rate hikes over the past year have simply been a ‘shadowing’ of market interest rates.
Nabiullina continued:
“The labour market – really, its condition – is a very important factor now in assessing the possibilities of expanding production, and companies still continue to cite it as the main constraint… But we do see the first signs of a decline in demand for labour. This process will be uneven across the economy, flowing from one industry to another, from one enterprise to another. This process will have a significant impact on our assessment and decision-making, including monetary policy.”
Again, she might indeed be right – I do also, based on my simulation, expect things to start to cool down quite a bit in the Russian economy, but I also expect inflation to continue to rise further.
In fact, what our simulations are indicating is that the Russian economy is increasingly heading for a stagflationary scenario – likely with inflation above 15% and basically no economic growth.
But I will happily acknowledge that Nabiullina is not to blame for this. It is 100% a result of Putin’s war on Ukraine – the massive budget deficit and major negative supply shocks it has created.
On the other hand, we can no longer consider governor Nabiullina ‘ultra-orthodox’, ‘prudent’ and ‘hawkish’ or any other words used to describe inflation-fighting central banks. This is simply a servant.
Economic Gravity – Not Overheating – Is Putin’s Primary Economic Headache
The fundamental misunderstanding of Russia’s economic trajectory stems from a failure to distinguish between monetary dynamics and structural economic deterioration.
Our model clearly demonstrates that what many Western (military) analysts interpret as “overheating” is actually the early manifestation of a complex monetary-fiscal nexus, one that will inevitably lead to stagflation rather than a simple boom-bust cycle.
Economic gravity sooner or later always sets in, and Russia’s case will be no exception. The laws of economics cannot be indefinitely suspended through monetary manipulation or statistical sleight of hand.
The apparent resilience of the Russian economy is largely illusory, sustained by massive monetary expansion and increasingly compromised institutional independence at the CBR.
What we’re witnessing is not the prelude to a classical overheating scenario (if such a thing ever existed), but rather the erosion of Russia’s productive capacity masked by aggressive monetary accommodation of fiscal deficits.
The simulation results point to an uncomfortable truth: Russia is not heading for a sudden collapse, but rather a grinding deterioration characterised by rising inflation and declining potential output.
This “slow burn” scenario is actually more pernicious than a quick boom-bust cycle, as it represents a structural decline in Russia’s economic capacity that will persist long after the immediate effects of the war have faded.
The transformation of the CBR from an independent inflation-fighting institution to an enabler of war financing represents more than just a policy shift – it signals the complete subordination of monetary policy to Putin’s military ambitions. Hence, Nabiullina’s position has evolved from independent monetary policy maker to facilitator of war financing.
Nabiullina’s recent policy decisions should be viewed not as prudent central banking but as evidence of this fundamental institutional change.
Looking ahead, the choice facing Russia’s economic leadership is increasingly stark: either allow inflation to accelerate while maintaining the fiction of price stability through selective data reporting, or impose increasingly draconian price controls that will inevitably lead to Soviet-style shortages.
Neither path offers a sustainable solution to the fundamental problems our model has identified. The real tragedy is that this outcome was entirely predictable from the moment Putin chose war over economic stability.
Try the RUST Model Simulation yourself
The model simulations above were based on modelling I did with the help of ChatGPT and particularly Claude 3.5 Sonnet.
I call this framework the RUST model — Russia’s Unpleasant Structural and Transitional economic model.
The acronym reflects both the theoretical foundation in “Unpleasant Monetarist Arithmetic” and the slow economic decay (“rusting”) of Russia’s economy under the weight of fiscal irresponsibility, war-induced supply shocks, and institutional degradation.
This also means that you can play with the model and its parameters.
History often rhymes, as Mark Twain is famously quoted as saying.
The story of Syrian President Bashar al-Assad’s flight to Russia—and the presumed transfer of his family’s substantial wealth to Moscow—offers a stark reminder of one of the most contentious financial episodes of the 20th century: the transfer of Spain’s gold reserves to the Soviet Union during the Spanish Civil War.
Known as the “Moscow Gold,” this episode highlights the precarious trade-offs faced by leaders and nations under siege. Both cases vividly illustrate how those who surrender control of their wealth to a more powerful benefactor often find themselves trapped in a gilded cage.
The Moscow Gold: A Historic Precedent
In 1936, as Spain’s Second Republic teetered on the brink of collapse under the onslaught of Francisco Franco’s Nationalist forces, the Republican government made a desperate decision. Over 510 tonnes of gold—72.6% of the Bank of Spain’s total reserves—were shipped to the Soviet Union.
This transfer, initiated by Finance Minister Juan Negrín and carried out in utmost secrecy, was ostensibly designed to safeguard the nation’s wealth and use it to purchase arms for the Republican war effort.
The logistical operation was both meticulous and clandestine. The gold was moved from Madrid to the naval stronghold of Cartagena, loaded onto Soviet ships, and transported to Odessa before arriving in Moscow. Upon receipt, the gold was carefully catalogued by Soviet officials and stored in the vaults of Goskhran, the Soviet state treasury.
Initially, the agreement seemed mutually beneficial. The Spanish Republicans would gain access to Soviet arms and supplies, while the Soviet Union would strengthen its influence over the Spanish Republic.
However, the reality was far less equitable. Once the gold was in Moscow, control shifted entirely to Stalin’s regime. By 1937, the gold was fully integrated into the Soviet state’s reserves, and the Spanish Republicans were left with little leverage.
The promised arms arrived sporadically, were often outdated, and were supplied at inflated prices that consumed much of the gold’s value. In the same way as Putin’s military support to Assad also suddenly disappeared.
The Fallout for Spain
The consequences for the Spanish Republic were devastating. The depletion of its gold reserves not only failed to turn the tide of the war but also left the Republic financially crippled. After Franco’s victory in 1939, the loss of the gold became a symbol of betrayal and desperation.
Efforts to recover the gold were futile, and its disappearance became a political and historical controversy that lingers to this day. For Stalin, the gold was a windfall that bolstered Soviet coffers at a time of global economic uncertainty.
Assad’s Gilded Cage in Russia
Now, almost 90 years later, we see a strikingly similar scenario playing out with Bashar al-Assad. Reports suggest that Assad’s flight to Russia included the transfer of substantial family wealth, likely accumulated during his decades-long rule over Syria.
This wealth, which was presumably intended to secure the Assad family’s future, now resides under the control of Vladimir Putin’s regime.
Assad’s position in Russia bears strong resemblance to the role played by communist leaders in satellite states like Bulgaria or Czechoslovakia under Soviet influence. Much like those figureheads, Assad’s autonomy appears minimal.
Putin has likely extracted all useful intelligence and strategic value from Assad long ago. Now, Assad and his family find themselves in a gilded cage, their wealth little more than another resource in Putin’s geopolitical arsenal.
Adding an ironic twist to this situation are the persistent rumours of discord within the Assad family. Some reports claim that Asma Assad, Bashar’s British-born wife, wishes to divorce and return to London.
If true, this rumour underscores the fractures in a family now bound by circumstances outside their control. Of course, such a move would be almost impossible. Putin, who effectively holds the Assad family’s fate in his hands, would have no reason to permit it. Moreover, Asma Assad would find no welcome in the UK, where her ties to the Assad regime have made her persona non grata.
Lars Christensen
Mail:
lacsen@gmail.com
Phone:
+45 52 50 25 06
Speaker agency:
See my page at my Speaker Agency Youandx here:
https://www.youandx.com/speakers/lars-christensen
