The narrative around the macroeconomy has summoned the scary specter of stagflation. The growth story is relatively clear. We have lingering recession signals from 2023 that never coalesced into a real recession; the changing policy landscape is a catalyst for realizing underlying weakness; tariffs are effectively a nominal tax with the same effects on output. The simple story for inflation is the same: tariffs raise prices on imports. For the sake of conversation, a lot of rhetorical weight rests on the definition of inflation. Politically, inflation is when stuff costs more. Tariffs will cause political inflation. Economically, inflation is a sustained increase in the price level of goods. Semantically, tariff implementation does not cause inflation because it represents a one-time increase in prices. So why are we all predicting inflation?

The Fed

This week the Bureau of Labor Statistics released revisions for hiring numbers from May and June. The initially reported job growth was downgraded to anemic numbers. In response, the implied market odds of a September rate cut jumped from 40% to above 90%. However, the latest inflation print – PCE numbers from June – jumped to 2.6% YoY, a 4-month high.

I’m not sure, though, that changing the Fed Funds Rate will mechanistically increase inflation. Indicators of monetary ease have been suggesting that conditions in funding markets have remained loose, despite a persistently high FFR. The latest economic cycle has been a story – in part – of income, rather than credit. The current marginal consumer is increasingly wealthier, whose income is in greater part linked to income-producing assets. Cutting rates would decrease the nominal income of the largest consumer base.

The Fed’s impact is its setting of expectations. The Fed has ostensibly held rates steady through 2025 for a stated fear of reigniting inflation. The price pressures they’ve discussed have not disappeared. A premature cut risks de-anchoring expectations if services inflation and other signals remain inconsistent with 2% target. Firms, no longer confident in a concerted policy effort toward 2% inflation, will begin directly pricing in their expectations into forward-looking contracts, reinforcing an inflationary push.

The Dollar

An alternative view of inflation is the drop in the purchasing value of a dollar against a basket of goods and services. Usually, the causality is thought of as flowing from inflation to the dollar; inflation weakens the purchasing power of the dollar relative to foreign currencies. Since such a large portion of goods consumed in the US are imported, the value of the dollar against foreign currencies has a large impact on the price of domestic goods. Tariffs were originally expected to raise the value of the dollar, offsetting the price increases. Instead, the new policy catalyzed a selloff of the dollar.

A bearish dollar is one of the most crowded trades. Non-commercial future positions – a proxy for speculative USD sentiment – are at their most shorted level in 5 years. Cyclical and structural forces are weighing on the dollar index.

Cyclically, the dollar has been historically expensive since COVID. The US’s strong post-pandemic recovery, rate differentials, and safe-harbor liquidity drove large global demand for dollar-denominated assets. The global economy has been incredibly long the dollar, so the geopolitical upheaval of April gave global asset allocators a justification for pivoting toward alternative markets. The increasing likelihood of a September rate cut also provides short term impetus for a bearish dollar. Historically, sovereign yields are correlated to the issued currency; a higher yield sees more inflows from investors.1 If investors expect the beginning of a cutting cycle, they’ll rotate into higher yielding assets.

Structurally, the global role of the US dollar is increasingly looked at warily. The dollar has been dominant as the final settlement of global transaction; 88% of FX trading involves the dollar, the dollar share of trade invoicing and cross border liabilities are around 50%, 70% of foreign currency global debt issuance is denominated in the dollar. We do not forecast this role to change catastrophically. There is no alternative with adequate infrastructure or depth of liquidity to handle the scale of flows. The moat-like protection of network effects creates a massive barrier to entry for a competitor system. However, global actors have begun development of alternative payment rails. China in particular has encouraged the expanded use of the renminbi in clearing cross-border transactions. They have used the politicization of US dollar rails – SWIFT sanctions and seizure of Russian USD assets – to

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push the transition to the Cross-border Interbank Payment System (CIPS) for renminbi transactions and the development of renminbi-denominated oil futures on the Shanghai Exchange. These efforts remain limited and won’t kill the dollar, but they limit the breadth of marginal actors in the US dollar system.

Tariffs

Ok. I know I said the tariffs won’t cause inflation. To clarify, the primary policy does not specifically drive a long-term change in price level. This intuition does not factor in the re-organization of trade networks. Tariffs and proactive trade policy do not just change the price of goods; they change the costs of transacting. For example, imagine you’re a Spanish wine manufacturer/exporter. You’re costs of goods were $30 per bottle, but now, there’s a 15% tariff on your export. Do you pay the difference out of your margin? Do you pass the price to the wholesaler? Also, previously you were paying $3 per bottle from a Chinese manufacturer. Do you pay an extra tariff based on transshipment policy?
This example happens globally. When the marginal cost increases on these decisions costs millions of dollars, firms may be forced to re-select suppliers and change the network structure of value chains. The free trade system optimized supply chains for marginal cost. Re-ordering the network of trade has inherit frictional costs and decreases in long-term efficiency

If trade policy continues to dynamically evolve, the strength of these frictions becomes increasingly relevant.

The Outlook

We project YoY PCE to max out at 3.5% in October/November 2025. This spike will reflect the initial primary rise in the price level from tariff implementation. Over the next 3-4 years, the inflation rate will settle closer to 2.5%, rather than the target of 2%. Structural realignment of global supply chains and the effects of persistently high deficits will limit the capacity of monetary policy to meaningfully fight inflation. In this base case, investors will need to prioritize actively preserving purchasing power as well as maximizing nominal returns.

Steven J. Wagner, Investment Adviser
Bray Farm Income Advisory LLC
3375 Brookdale Drive, Pittsburgh PA 15241
412.504.9412
412.848.2410 (cell)

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