America’s very awkward inflation problem

Less than a week before Donald Trump’s inauguration, today’s data showed annual inflation rising for the third consecutive month in December.

15 January 2025

Inflation, and its unwillingness to cool, was arguably why the Biden administration failed to secure a second term. Which makes it all the stranger that US equities perked up (and bond yields fell) on the back of the news that headline US CPI was ‘just’ 2.9% while core CPI excluding food and energy was 3.2%. That the market was expecting these figures to be even higher perhaps explains the relief but worryingly also suggests that no one seriously believes inflation will fall below the Federal Reserve’s (Fed) official target of 2% anytime soon, least of all the Fed themselves.

Indeed, they are now widely expected to leave interest rates where they are at 4.5% (Fed Funds upper bound) at their meeting later in January, while futures markets are not pricing in a cut now until later in the year. This is problematic because both short and long-term US interest rates are relatively high and starting to exert pressure on an already fully valued US equity market. Indeed, with the forward earnings yield on the S&P 500 barely more than 4%, the 4.5% and 4.8% offered by said near term rates and the 10-year US Treasury bond respectively are making US stocks look relatively unappealing. And this is without even considering the effect on housing and the real economy.

What then could bring inflation – and therefore rates – down?

Perhaps the question is better framed as what could stop inflation from rising further from here, since various Trumpian policies look distinctively inflationary rather than disinflationary in nature. Take for example the desire to eject undocumented migrants from America. Many of the estimated (by Pew Research) 11 million undocumented migrants in the country work in services and hospitality, so removing them without an obvious replacement would likely send wage rates in those sectors soaring. And that’s before taking into account high skilled visa programmes like H-1B, the prospect of tariffs and the turbocharging effect of deregulation and renewal of the 2017 tax cuts. This latest inflation datapoint surely then serves as a warning that the inflation fight is far from over and may in fact be entering an unwelcome second phase. While the futures market is not pricing in outright monetary policy tightening by the Fed as mentioned, some serious economists are now openly discussing that very possibility. All this just days before the inauguration.

Unvanquished – US inflation just won’t sink back to pre-2020 levels:

From 31 Dec 2014 to 31 Dec 2024