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Good morning. The world had a taste of Greenlandic tacos yesterday when Trump reneged on the European tariffs he had threatened after reaching “the framework of a future deal” with Nato’s secretary-general. Markets cheered: bond yields fell and stocks rose. Is it really over? Email us your thoughts: unhedged@ft.com 

The case for higher inflation in 2026

Most economists and market participants think that the US has inflation more or less beaten. Yes, inflation is still somewhat above target. And yes, if the president manages to pack the Fed’s Open Market Committee with sock puppets, we could backslide. But the numbers are heading in the right direction, and simply replacing the Fed chair with a toady, which seems likely to happen, will not be enough to upset the balance on the committee.

Unhedged has gone along with this consensus view. A sudden increase in inflation would absolutely wreck the current rosy economic set-up, and inflationary incidents do tend to cluster together historically. But we have characterised inflation as a low-probability, high-damage risk.

Adam Posen of the Peterson Institute and Peter Orszag of Lazard disagree. In a recent presentation, they argue that lagging tariff effects, fiscal and monetary looseness, a smaller immigrant workforce, and an upward drift in inflation expectations all suggest that inflation could well exceed 4 per cent by year-end. The crucial bits of the argument:

Tariffs will bite us yet: “The many reasons for the lagged pass-through [of tariffs to consumer prices] include businesses pricing based on when their inventories arrived (and have since run out) and concerns around being seen as raising prices too rapidly (so they are instead gradually increasing them). This won’t last — historical evidence shows that tariff pass‑through tends to be gradual, with consumer prices rising only as firms revise pricing with a lag.”

Wages will too: “Lower immigration and deportation have not led to any sign of lower employment or output in sectors that depend on immigrant labour — agriculture, food processing, residential construction, health and child care.” Nor are there signs of increased automation, higher wages or higher native-born employment in these sectors. This is not a stable equilibrium. Wages in these sectors will rise.

Fiscal: “The fiscal outlook for 2026 is more expansionary than most recognise — and may add a per cent of GDP or more in additional stimulus this year.” The tariff burden is decreasing as companies adjust. Republican giveaways in the form of healthcare subsidies and tariff “dividends” are in the offing. An underfunded Internal Revenue Service may collect less taxes. 

Monetary: Financial conditions are looser than they look because credit spreads are historically tight, households and companies have low debt burdens, and private credit funds have splashed $2tn in financing. High investment in defence, industrial policy and AI also pushes the neutral interest rate higher.

Inflation expectations: Professional forecasters and bond markets may see inflation as well under control, but households take a different view. “As staggered price increases in salient categories [such as food] materialise over the next year, household expectations could drift upward, which also puts upward pressure on actual inflation.” More to the point, Posen has asked elsewhere, “can expectations really be as anchored now as in 2019?”

I can think of four main objections to this view.

If we have learned anything in the past five years, it is that people are bad at predicting the timing of inflation. Several people correctly predicted the 2021 burst upwards; but none of those people, so far as I know, were right about how quickly inflation would decline in 2022 and 2023. I put this historical point to Posen. His response: “We know more about how long some specific types of inflation take to pass through than others. No one knew how long it would take economies to reset after pandemic reopening. That is an argument that certain people should have been more humble in their predictions then, but not as much of a caution now.” 

Productivity will bail us out: If workers can produce more with the same amount of work, consumption can rise while prices stay stable. “Higher productivity is partly a structural story, but I now think it’s a structural response to AI — it looks like the 90s,” says Paul Ashworth of Capital Economics. Posen replies that (a) it is not clear that the recent productivity gains are from AI (b) positive supply shocks from new technologies often cause higher real growth, not just lower prices (c) in the near term the AI investment boom may cause inflation in things like power, commodities and specialised labour.

The idea of long lags for the tariff and labour shocks is just unconvincing. “If the labour shock is real, it should also be slowing the economy, and we are not seeing that much in nominal income growth. It’s at 5 per cent,” says Ed Al-Hussainy of Columbia Threadneedle. “Are we really saying that, nine or 10 months later, firms are going to have to pass prices trough now? I mean, give us a break,” says Ashworth.  

Even if Posen and Orszag are right, the Fed can always raise rates and kill inflation’s resurgence quickly. Yes, the Fed was late in 2021, but when it finally acted, it worked. But Posen thinks the Fed will be late again, with “no one wanting to raise right before the [midterm] elections, and with people making the argument (some sincerely, some not) that these are first-round effects of supply shocks and productivity is coming, so we should wait. By then . . . the FOMC will be well behind the curve for the second time in just a few years.” 

My own view, as of now, is that the general point about fiscal and monetary looseness is probably correct. With markets still at their highs and consumption and investment still humming, it’s hard to credit the idea that monetary policy is restrictive in any meaningful sense (the housing market is a crucial exception, but I think the issues there are unique). It is also clear that Republicans will be looking for an excuse to open the fiscal spigot further. I agree, too, the market-based measures of inflation expectations seem inconsistent with the plain fact that everyone is worried about further inflation now. What I am not confident of is the outlook for tariff- and labour-driven inflation, which are central to the Posen/Orszag case. I suspect that the mechanisms are too complex to predict. I am curious to hear what readers think.

One good read

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