Observations: Ball’s in your court, Jay

Tariffs are a cost shock; inflation is up to the Fed

Markets have spent the last few weeks learning to dance with an elephant. As I warned after the election, Donald Trump planned a full-scale Revolution in American governance, policy and its relationship with the world. And unlike in 2016, he is much better prepared to effect it. But all revolutions – even with the best laid plans – are chaotic. Markets, like much of the commentariat, domestic opponents, and many foreign leaders, are shocked, confused and increasingly pessimistic on US prospects.

Amid the Trump torrent, one of the most important economic questions regards the path for inflation and its interaction with economic activity. I.e., should we expect (1) Cost-push inflation with stable growth? (2) Demand-pull disinflation with weakening growth (or a recession)? (3) Stagflation? (4) Or, is a miracle possible and we get stable growth with near-target trend inflation? The answer to that question not only dictates the paths for real and nominal US rates, but for US equities and the dollar. It also will have a major influence on sovereign yields outside the US.

As I noted in my Leitmotifs for 2025, there are Too many moving parts to make any calls with high conviction, but the most important determinant in answering this question will be how the Fed returns the ball it is served.