Disinflation Resumption
Disinflation, not just despite, but perhaps because of tariffs, the FOMC is likely to fall further behind the curve, changing currency correlations suggest structural changes
Note: We will be in NYC this week
Validation and Vindication
The equity market response to the Liberation Day Trump Trade Shock was unequivocal, market participants screamed tariffs would reduce output (GDP), income (GDI), revenues and earnings, which would swamp the first order effect on the rate of inflation. The Treasury breakeven inflation curve (Figure 2) went deeply negative, just like April ‘22 just before the June ‘22 pandemic inflation peak, discounting lower, not higher inflation after the initial shock. In short, sharply higher tariffs were not inflationary, they are disinflationary. Meanwhile, the elite technocrats at the Fed with their Bayes Rule biased priors, homogeneity of economic thought and the economics community that supports them, told us to ignore what we saw on our screens, and insisted tariffs are inflationary. A key factor in our antithetical view of the price impact of tariffs is the larger weight we place on fiscal policy in the inflation process, as well as our view that Friedman’s monetarism was not wrong, it just needed a more robust model for the velocity of money (a topic for another day).
We’ve said it before, and we’ll say it again, inflation is always and everywhere a monetary and fiscal phenomenon. The monetary and fiscal policy settings are much tighter than in ‘21, consequently, increases in tariffs may increase some goods prices, but they appear to be reducing aggregate demand and gross income, and disinflation has resumed. The median monthly annual growth rate of M2 since 1960 is 6.66%, the current rate is 4.45%. it peaked in early ‘21 at 26.7%. While the Federal government spending is tracking 23.4% of GDP for fiscal year ‘25, well above the 20.3% median since 1981, and direct transfer payments to individuals as a percentage of disposable income are 2% above the pre-pandemic rate at 18.7%, in ‘21 spending was 29.75% of GDP and transfer payments were 33% of disposable income. In other words, monetary and fiscal policy are orders of magnitude less accommodative than was the case in ‘21.
As we move into the back half of President Trump’s second term, the inflationary impacts of the Fed’s large balance sheet of longer maturity securities and elevated government spending relative to the 50-year median rate, as well as a further weakening of the deflationary impulse from globalization, suggest trend inflation will be higher in the ‘20s than the ‘00s and ‘10s. That said, in 2025 disinflation in housing and non-housing services, combined with excess global goods capacity due to that fatal conceit of central planning in Asia and Europe (think autos), will put downward pressure on inflation, tariffs or not. The markets message from the April Trump Trade Shock was clear, and the ‘hard’ activity and price data in June is validating the market response in April and ‘soft’ sentiment data in May.
The Treasury market has round tripped following an overreaction sell off to stronger than expected headline payroll growth, despite weak internals. Equities are grinding higher towards new highs led by the artificial intelligence investment boom beneficiaries and economically sensitive cyclical sectors as trade policy uncertainty recedes, tax policy expectations improve, and benign inflation reports lower policy rate expectations. Perhaps the most interesting price action is in exchange rates, the dollar is weakening relative to gold, bitcoin, the euro and the Asian managed (some might call them manipulated) exchange rates, most notably the Taiwan and Singapore dollars, as well as Korean won.
In this week’s note we will review the CPI, PPI, Atlanta Fed Wage Tracker data. We will preview the FOMC meeting, explore who will buy our bonds and the impact of tariffs on margins with 2Q25 earnings season a month away. We have lots of thoughts on Israel’s attack on Iran, however, we are going to take our lead from the Treasury market’s muted reaction (2s +2bp and 10s +1bp early Friday and up a few more through the session) and assume the risks to asset prices are minimal. We suspect a pullback could develop during earnings season in a month’s time; we doubt the conflict in the Middle East will be the catalyst for a significant risk off episode.
