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What is going on with inflation, tariffs and inflation expectations?

Despite what anyone may boldly proclaim, this is an incredibly uncertain time for forecasting inflation. This is making the Fed’s job particularly difficult, which is leading to rising investor uncertainty and volatility.

On the positive side for lower inflation we have:

the most aggressive Fed tightening cycle in at least 40 years
a likely recession coming as a result of this tightening

On the negative side for higher inflation we have:

Trump’s proposed (but always changing) tariffs (which, like all taxes, are also bad for the economy)
rising consumer inflation expectations, which can lower the demand for money and lead to higher prices

Let’s take a look at the latest data to try to sort this out, as inflation will have significant implications for Fed policy and financial markets.

PCE Inflation Slowed In March

The good news on the inflation front is the three key PCE inflation metrics all slowed in March. PCE inflation (blue line) slowed from 2.7% in February to 2.3% in March, as shown in the chart below. Core PCE inflation (red line), excluding food and energy, slowed from 3.0% to 2.6%. Fed Chair Jay “Transitory Inflation” Powell’s preferred inflation measure SuperCore PCE inflation (core services inflation excluding shelter prices; green line) slowed from 3.6% to 3.3%. Unfortunately, that is still 65% higher than the Fed’s 2% target. Thus, Americans are still paying the price five years later for the Fed’s reckless 40% increase in the amount of US dollars in 2020.

PCE inflation

But will this slower inflation be “transitory”, to use Powell’s term, due to tariffs and rising inflation expectations?

Consumer Inflation Expectations Are Rising

This chart shows that Trump’s proposed tariffs (aka taxes on imports) are the highest since the Smoot-Hawley tariffs of 1930 which contributed to the severity of the Great Depression. That is not an encouraging precedent.

Tariffs

Higher tariffs are feeding into higher consumer inflation expectations, as this chart from the University of Michigan consumer survey shows.

Inflation expectations

University of Michigan consumer survey director Joanne Hsu explained what is going on with inflation expectations as follows:

“Year-ahead inflation expectations surged from 5.0% last month to 6.5% this month, the highest reading since 1981 and marking four consecutive months of unusually large increases of 0.5 percentage points or more. This month’s rise was seen across all three political affiliations. As seen in the chart, inflation expectations evolved with major trade policy announcements this month. After the April 9 partial pause in tariff increases, inflation expectations ebbed but remained substantially elevated relative to March. Long-run inflation expectations climbed from 4.1% in March to 4.4% in April, reflecting a particularly large jump among independents.”

Retail Investors: What, Me Worry?

Incredibly, individual “retail” investors (aka “dumb money” according to Wall Street) could care about these tariff and inflation concerns. In fact, retail investors bought a net $40 billion in stocks in April, which set a new record for the largest monthly stock buying ever by retail investors. This chart shows that high net worth “private clients” have been buying stocks for 21 straight weeks, the longest buying streak since the data started being collected in 2008.

Retail buying

Retail investors are notorious for buying at tops and selling at bottoms. Thus, their recent behavior is not encouraging, to say the least.

Investment Implications

Right now there is a tug-of-war between slowing inflation and rising inflation expectations due to Trump tariff concerns. But one thing both slowing inflation and tariffs have in common is a recession. Slowing inflation is typical in a recession and big tariff hikes, like any big tax hike, can help cause a recession after aggressive Fed rate hikes. This is why 2025 is likely to be a highly volatile and challenging year for investors.

TOUR