Inflation fears add to pressure on Federal Reserve

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US bond traders have moved to price in a burst of inflation from Donald Trump’s tariff war, piling pressure on the Federal Reserve as it seeks to cut interest rates to support an economy that is being punished by the administration’s trade policies. 

Global markets slumped on Thursday, sending investors flocking to safe assets, as Trump’s tariff plans, including a baseline duty of 10 per cent but with double-digit top-ups on trading partners such as the EU and China, came in much tougher than expected. 

It also added fuel to a sharp rise in market expectations of short-term inflation in recent days, with one-year inflation swaps — derivatives that provide a market view of inflation expectations — rising close to 3.5 per cent on Thursday, their highest level since 2022. 

The surge in inflation expectations underscores the fiendishly difficult trade-off facing Fed chair Jay Powell as he balances the prospect of jumping prices alongside weakening GDP growth.

“The increased risks to both inflation and employment put the Fed in an even greater bind going forward,” said Krishna Guha, vice-chair at Evercore ISI. “Fed officials will fear tariffs are so large and so messy that they will contaminate underlying inflation and unhinge inflation expectations”.

Scarred by the inflation surge that followed the end of the Covid-19 lockdowns, the central bank is anxious to prove it takes its inflation-fighting mandate seriously, even as it responds to a weakening US consumer.

Growth prospects have waned in recent weeks as the prospect of surging import prices and stifled corporate sentiment raises fears that the US is slowing sharply or even flirting with recession.

Markets have responded by pricing in faster Fed cuts. Investors are now pricing in four quarter-point rate cuts by the end of this year, according to levels implied by futures markets, from the three before Trump’s tariff move.

At the same time, the president’s plans for higher tariffs on a range of imports have pushed consumer inflation expectations higher, complicating the Fed’s task if it wants to shore up the economy with lower borrowing costs. 

JPMorgan strategist Jay Barry warned that the tariffs announcement “suggests an even larger near-term increase in inflation and negative hit to growth than markets were anticipating”.

Austan Goolsbee, president of the Chicago Fed, last week warned that evidence investors in the US bond market were baking in higher inflation would be a “major red flag” that could upend policymakers’ plans to cut interest rates. 

Longer-term inflation expectations have been more stable, with the five-year swap — showing the average expected inflation over the period — hovering around 2.5 per cent, suggesting that bond markets view the trade tensions, and the inflationary effects of other Trump policies, as shorter-run effects. 

Mike Riddell, a bond fund manager at Fidelity International, said markets had taken the view that tariffs were inflationary in the short term. However there was also a “danger” that there would be deeper supply chain disruptions that continued to feed inflation down the line, he warned.

If policymakers form the view that the tariff-induced price surge is a one-off shock that will fade after this year, they may feel able to focus more on cushioning the damage to demand and employment. But memories of the post-pandemic inflationary upsurge are fresh in the minds of consumers and business chiefs, meaning price expectations are vulnerable to being unsettled again. 

The steadiness of longer-term inflation measures “suggests that the market thinks this is — dare I say — a transitory burst of inflation”, said Gennadiy Goldberg, head of US rates strategy at TD Securities.

However Andrew Clare, a professor at Bayes Business School, said the tariffs were presenting a problem that central bankers “could do without.” 

“The big question is: how will central banks, and in particular the Fed, respond to the likely rise in inflation? If they put rates up this will punish businesses and consumers further. If they do nothing, or even cut rates to stimulate demand, this could fuel further inflation.”

Investors said the move in short-term expectations was more pronounced given that oil prices — usually a big driver of investors’ short-term inflation expectations — had fallen this week as worries grew on global growth. And it comes at a time when consumer expectations of inflation are surging. 

Speaking at an event in London before the Trump announcement, Dan Ivascyn, chief investment officer at bond giant Pimco, warned of the “risk that as long as we stay in this environment of elevated inflation, it does begin to get more embedded”.