Market-Based Inflation Expectations: Are They Too Low?

What You Need to Know

The Trump administration’s tariffs—25% on Mexican and Canadian imports, 10% on Canadian oil, and 10% on Chinese imports—significantly increase the probability of more inflation volatility. These measures also decrease the likelihood of supply-side improvements in the economy. Additionally, the link between tariff revenue and tax cuts suggests that sustained tariff increases may be more likely than anticipated.

Investing for Income: The Opportunity in Bonds

Bonds may present an attractive entry point for long-term investors.

Before diving in, it’s important to note that the situation regarding U.S. tariffs on Canadian and Mexican imports—first announced on February 2—is evolving. As of February 3, the Trump administration announced a delay on tariffs imposed on Mexico, reflecting the fluidity of the situation. However, I will outline the original tariff plan and its potential economic outcomes.

Unpacking Trump’s Tariffs

On February 2, Trump invoked the International Emergency Economic Powers Act (IEEPA) to impose tariffs aimed at curbing fentanyl movement and illegal border crossings. The key tariffs include:

• 25% on all Mexican and Canadian imports
• 10% on Canadian energy
• 10% on Chinese imports

Further exemptions and carveouts are possible before implementation.

Economic Impact

• Imports Affected: The U.S. imported $410 billion from Canada (1.3% of U.S. GDP), $503 billion from Mexico (1.7% of GDP), and $440 billion from China (1.5% of GDP) in the last 12 months.
• Inflation Outlook: At face value, these tariffs imply a 0.7 percentage point increase in core personal consumption expenditure (PCE) and a 0.5% hit to economic growth.
• Dollar Strength Impact: A stronger U.S. dollar and conservative assumptions on passthrough imply a 0.5 percentage point increase in core PCE—a substantial shock to short-term inflation.

Trump’s statements suggest the tariffs will take effect on February 4, and his rhetoric implies limited near-term options for affected countries to prevent them. However, IEEPA allows for rapid implementation and reversal, meaning negotiations could lead to changes.

If no progress is made on border security, fentanyl movement, or trade imbalances, tariffs may increase further.

Global Impact

While Europe and Japan have avoided the first round of tariffs, they may not be in the clear. Trump hinted at European tariffs in the near future, potentially following the confirmation of USTR nominee Jamieson Greer. Expect at least a 10% tariff on European and possibly Japanese imports in the coming months.

Implications for Market Growth and Inflation Expectations

The biggest gap between 12-month forward-market expectations and Federal Reserve (Fed) forecasts lies in inflation assumptions:

• The Fed projects core PCE at 2.5% in 2025 and 2.2% in 2026.
• With tariffs, this assumption appears outdated, as inflation could rise faster.

How Markets May React:

• Stronger U.S. dollar and lower equities could tighten financial conditions.
• Inflation volatility may increase, affecting investor sentiment and financial stability.
• De-globalization trends may accelerate, leading to sustained inflationary pressures.

Implications for the Fed and Fiscal Policy

Basic economics suggests tariffs are inflationary in the short term but disinflationary in the medium term due to negative growth effects. However, given four consecutive years of inflation above the 2% target, inflation expectations may rise, leading to higher front-end breakeven inflation rates.

Current Market Pricing:

• Over 40 basis points of rate cuts are priced in by year-end.
• The Fed may prioritize controlling inflation, delaying cuts or even considering a rate hike if inflation expectations surge.

Fiscal Policy Considerations

• Extending the Tax Cuts and Jobs Act will cost $5 trillion over 10 years.
• Without cuts to Social Security, Medicare, or defense spending, balancing the budget is nearly impossible.
• Tariff revenue is the primary funding source for Trump’s tax and spending proposals, making tariffs a key policy lever.

What’s to Come?

After a post-election market boost, equities have remained flat for two months, while bond yields have risen. Tariffs increase the likelihood of a market correction, tightening financial conditions further.

Trump has already laid the groundwork to blame the Fed for adverse market reactions, rather than his tariff policies.

Possible Scenarios:

• Negotiations and Reversals: Tariffs may be rolled back, depending on diplomatic progress.
• Higher Tariffs: If no progress is made, expect additional increases.
• Policy Trade-offs: Canada is unlikely to consider U.S. statehood negotiations, but progress on border security and drug trafficking issues could influence talks.

The Bottom Line

Key Takeaways:

• Higher probability of increased inflation volatility.
• Lower likelihood of supply-side improvements in the economy.
• Tariff revenue is crucial for Trump’s tax and spending plans, suggesting sustained tariff increases.
• Trump is following through on his campaign promises, which has broader implications for trade policy.

What Should Investors Do?

Given the uncertain policy landscape, talk to your financial professional to understand how shifting policies may impact your investment portfolio.

Important Disclosures

Investing involves risk, including possible loss of principal.

The views expressed here are those of Wellington Management and are for informational purposes only. They do not constitute investment advice, nor do they reflect the opinions of Hartford Funds or any other sub-adviser. Views may change based on evolving market conditions. This content may not be reproduced or distributed without written consent from Wellington Management or Hartford Funds.

Key Financial Terms:

1. Personal Consumption Expenditures (PCE): Measures the value of goods and services purchased by U.S. residents.

2. Basis Point: A unit equal to 1/100th of 1%, used to denote changes in interest rates, equity indexes, and bond yields.