Should we throw in the “higher inflation” towel?

The US President insisted that inflation would not be an issue, as tariffs would be “paid for by exporters”. Yet, despite 96% of tariffs being paid for by importers, American inflation has yet to skyrocket as predicted.

If anything, it slowed down from 2.7% in November to 2.4% in December faster than projections. What is even more maddening is that neither other data (like PMIs, Chinese producer inflation climbing, Core PCE at 2.8% and food inflation at 3%), nor the Fed’s own projections seem to be consistent with such low headline inflation.

As expected, the market reacted broadly positively to the data, with investors now pricing in close to three rate cuts by the end of 2026, as opposed to one, which is projected by the Fed Dot Plot (a tool incoming Chair Kevin Warsh wants to dispense with).

It should come as no surprise that the 10-year yield is now trading at the lower end of the 4%-4.5% range of the last two years.

Was the president simply right that tariffs (which I remind you are not being “paid for” by foreigners) are not necessarily inflationary? Is the apocalypse coming with a lag, once the lower oil price effect is removed from the data? Is the data being skewed by the previous shutdown, where some items, like rents, were not counted and only inferred?

Until we have proof of the opposite, we will continue to trust the validity of US statistics. Our House View, at this point, is that 2026 US inflation will average between 3% and 4%. While this seems high versus the last 2.4% reading, we will need some more evidence before we revise it. PMI surveys, which are usually very reliable, suggest surging goods inflation and moderate services inflation. A persistent deficit close to 6% is inflationary too. When 2025 lower oil prices wash out of the data, tariff pass-throughs increase and pre-tariff inventories are depleted, we should have a clearer picture.

There is an argument to be made, and in fact has been made by both Fed Chair Nominee Kevin Warsh and Treasury Secretary Scott Bessent, that AI has a deflationary effect. While we have yet to see solid productivity gains from AI, in previous weeklies, we indeed noted that the Second  Industrial Revolution resembles the Fourth and Fifth industrial revolutions, the automation of the services sector (4th) with AI and the cooperation between man and machine (5th).

Mr Warsh’s wish to significantly reduce the Fed’s balance sheet and refrain from becoming the governments ubiquitous debt purchaser could impose fiscal discipline and provide a disinflationary impetus to balance the inflationary effect of the trade war.

Mr Warsh’s intentions alone, however, could come at a cost to growth. Fiscal expansion has allowed President Trump to claim economic success in a Midterm year. According to the Tax Foundation, the average taxpayer in 2026 will get $3800 back from the government, compared with $3000 in the previous two filing seasons. Curbing fiscal expansion has a lot of advantages, especially given the high debt burden, but it’s not conducive to growth. While we do hear the echoes of the Second Industrial Revolution, simply put, it would take an industrial-scale success of AI in a very short time for the economy to grow at those levels, and a very strict fiscal jacket to prevent this growth from becoming inflationary.

However, given the debt burden, we do believe that the US government is comfortable with higher-than 2% inflation level and a weaker Dollar. 

What this means for businesses

The Fed and the US government have their work cut out for them if they want to avoid increasing debt servicing costs. Already, the US is spending 12.5% of tax receipts just to cover interest expenditure.

Further fiscal expansion will likely mean higher inflation and borrowing costs. A Fed straightjacket on fiscal expansion could stifle growth. US businesses should be prepared for both eventualities. European and UK businesses, who are seeing a challenge to growth from the American demand shock, are not as exposed to potentially higher inflation.

What this means for investors

Despite the number on Friday, our thesis remains, for the time being, we wonder whether long bond investor are appropriately rewarded for risk. We remain in the camp of “inflationary boom”, rather than “deflationary boom”, and 2.4% inflation would probably be at the lower level of what we would expect to see going forward.

GBP Total returns to Friday close

Market update

On Friday, the US Supreme Court struck down a large portion of President Trump’s tariff programme. US equities had struggled to find a direction over the earlier part of the week amid a barrage of data releases but jumped around 1% on the news of the decision. Against that backdrop, US equities closed higher by +1.1% in dollar terms over the holiday-shortened week, rebounding from the previous week’s losses, even as investors continued to assess the earnings implications of AI spending and disruption. In the UK equities increased by +2.6%, supported by expectations for lower interest rates following Tuesday’s UK Employment Report, which highlighted softening labour market conditions, and Wednesday’s UK CPI print, which showed further disinflation and reinforced expectations that inflationary pressures might be easing. EU equities also gained +2.5% in price, as market sentiment was helped by rising earnings expectations and a more resilient European macro backdrop. Emerging market equities were also up +1.6% in GBP terms. Japan’s CPI release showed inflation cooling, which contributed to a more measured tone in Japanese equity markets into the end of the week, which closed at -1.0% lower.

In the US, the Federal Open Market Committee (FOMC) minutes were interpreted as more cautious on further easing, with some discussion around maintaining restrictive policy until inflation progress is clearer, which contributed to a firmer tone in yields. By Friday, the 10‑year Treasury yield had risen by +3 basis points. In the UK, softer domestic inflation data combined with evidence of cooling in the labour market supported gilt performance. The 10‑year gilt yield drifted lower through the week and ended -6 basis points lower.

In the commodities space, gold rose by +2.5%, particularly toward the end of the week, consistent with continued demand for defensive assets amid ongoing policy and geopolitical uncertainty. Oil moved significantly higher by +7.1%, driven largely by a widening Middle East risk premium linked to US-Iran headline developments.

Macro news

UK: weak labour data and cooling inflation. UK data this week painted a clear picture of a cooling economy. The unemployment rate rose to 5.2% in the three months to December—its highest in nearly five years—highlighting weakening labour‑market conditions. At the same time, wage growth slowed, with average earnings increasing only 4.2% in the three months to December, below expectations and signalling easing pay pressures. Inflation continued to cool as headline CPI fell to 3.0% y/y in January, down from 3.4% in December, while core CPI dipped to 3.1%, its lowest since August 2021—all of which strengthens market conviction that the BOE may begin cutting rates as early as May.

US economy shows resilience amid some soft spots. Manufacturing data was firm, with both the Empire State (7.1) and Philly Fed (16.3) indices comfortably in expansion territory. Core durable goods orders were up 0.6%—highlighting steady business investment. However, housing remained weak as pending home sales continued to contract amid high borrowing costs.

Oil prices surged amid worries about the potential for imminent US action against Iran. ICE Brent rallied, settling above $70/bbl. Amid military drills, Iran temporarily closed part of the Strait of Hormuz on Tuesday.