As markets hang on every word from the Federal Reserve, a seismic shift in monetary policy could be just around the corner—and I don’t think investors are fully ready for this – yet.
While Wall Street continues to bet on further rate cuts, the data tells a different story. Inflationary pressures are rising, consumer expectations are shifting, and the Fed is quietly signaling that the era of rate cuts is over.
This pivot could catch markets off guard, triggering a major stock market correction.
Revisiting the Mankiw Rule: Why It’s Still Relevant Today
The Mankiw Rule has long been used as a reliable guide to predict Federal Reserve policy. I have earlier written about the Mankiw Rule and suggested an improve version which I have termed the Theoretical Mankiw Rule. This my post “Eeny, Meeny, Miny, Mankiw: The Surprisingly Accurate Way to Guess Fed Policy” from July 2024 here.
The formula is straightforward but powerful:
Clik here to view.
This framework captures the core elements of the Fed’s dual mandate: inflation and unemployment. By applying recent data, it becomes clear that the Fed has little room to ease policy further without risking runaway inflation.
The graph below shows the updated Theoretical Mankiw Rule with the latest data included. I have furthermore conducted a simulation for interest rates for the remainder of 2025, where I assume that inflation will decline to 2.5% from the present 2.8%, and unemployment will increase to 4.5% from the present 4.1%.
Clik here to view.
Both of these assumptions actually mean LOWER rates, but the problem is that we will still have too high inflation relative to the Fed’s 2% target, and that interest rates presently are too low compared to the Theoretical Mankiw Rule.
Furthermore, there are good reason to believe that this is far too conservative assumptions. Inflation could very well spike a lot more on Trump’s planned tariffs and there are in my view signs that the natural interest rate now is being pushed up – for example by increased defense spending in Europe, geopolitical concerns and the fact that the Trump administration are unlikely to deliver on fiscal consolidation.
In fact this mean that the Fed should maintain or even increase rates in response to rising inflation and a resilient labour market.
Inflation Expectations Are Rising Rapidly
One of the most concerning developments is the surge in consumer inflation expectations. According to the University of Michigan’s latest survey, inflation expectations for the coming year have jumped from 2.8% in November 2024 to 3.3% in January 2025.
This rise in expectations is not happening in a vacuum. Tariff concerns have been a major driver of inflation anxiety. As the University of Michigan pointed out:
“Nearly one-third of consumers spontaneously mentioned tariffs as a concern, up from 24% in December and less than 2% prior to the election.”
Consumers worry that these tariffs will push prices higher, and their concerns are now reflected in inflation expectations. This is a critical data point that the Fed cannot ignore, and it raises the risk that the central bank will need to tighten policy sooner rather than later.
Tariffs, Inflation, and Trouble Ahead: The Fed’s New Reality
The rise in inflation expectations comes against a backdrop of Trump’s tariff policies, which continue to create uncertainty in global trade. These tariffs are effectively a tax on consumers and businesses, driving up the cost of goods and services.
The Fed’s latest FOMC minutes show that policymakers are increasingly concerned about these upside inflation risks:
“Almost all participants judged that upside risks to the inflation outlook had increased.”
This shift in tone suggests that the Fed is moving closer to pausing rate cuts and may even consider rate hikes if inflation continues to surprise to the upside.
The Market Disconnect: Why Wall Street Isn’t Ready
Wall Street remains overly optimistic about further rate cuts. The disconnect between market expectations and the Fed’s outlook is stark. Equity markets are priced for perfection, with valuations near historic highs. But if the Fed shifts gears and starts to tighten policy, those valuations could come crashing down.
Here’s why:
- Rising inflation expectations mean the Fed has less room to cut rates.
- The Fed’s neutral rate is higher than markets expect, suggesting that the current rate is already close to where it needs to be.
- Tariffs and fiscal policies are creating inflationary pressures that the Fed must address.
In other words, the market is betting on a scenario that the Fed itself is not endorsing. This disconnect could result in a painful market correction if investors are forced to adjust their expectations.
From Easing to Squeezing: The Fed’s Next Pivot Could Bring Pain
The Fed’s pivot from easing to tightening will likely be gradual, but the market impact could be sudden. If inflation continues to surprise to the upside, the Fed will have no choice but to tighten monetary policy faster than markets anticipate.
This is where the Theoretical Mankiw Rule becomes particularly useful. My updated calculations show that the Fed funds rate should remain stable or even rise over the next two years to keep inflation in check. Yet markets are still pricing in rate cuts, creating a dangerous mismatch.
Eeny, Meeny, Miny… Panic? The Market May Not Be Ready for What Comes Next
The current state of US equity markets is concerning. Almost every valuation metric suggests that stocks are expensive.
The S&P 500 is trading at levels that assume a continued easing of monetary policy. But what if that easing doesn’t come?
The most likely trigger for a correction is a renewed focus on inflation and the Fed’s response to it. If inflation picks up faster than expected and the Fed is forced to act, we could see a 10-20% drop in the S&P 500 over the next 3-6 months.
Investors should brace for volatility. The Fed’s pivot is coming, and the market is not prepared. When the realization hits, panic could set in.
Conclusion: No More Cuts, But Plenty of Bruises
There are clear signs that the Fed is done with rate cuts. Inflation data, consumer expectations, and the Fed’s own communications all point to a shift in policy. Markets, however, continue to price in further easing, creating a dangerous disconnect.
The risk of a significant correction in US equities has increased. As inflationary pressures mount and the Fed pivots from easing to tightening, investors should prepare for bruises. The era of easy money is ending—and the market’s not ready.
If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.