The Return of Inflation Fears
US inflation fears are back. Therefore, I have decided to revisit and update my favorite inflation forecasting model for the US – the P-star model.
In my recent post “Eeny, Meeny, Miny… Panic?”, I warned that markets are too optimistic about Fed rate cuts, with the (Theoretical) Mankiw Rule suggesting rates are already too low relative to fundamentals.
With M2 growth accelerating and inflation expectations rising, it’s time to examine what the P-star model tells us about inflation risks.
The model proved remarkably prescient in predicting the 2021-23 inflation surge when most observers, including the Federal Reserve, viewed inflation risks as “transitory.”
In April 2021 I correctly warned based on the P-star framework of an coming sharp spike in US inflation in my post Heading for double-digit US inflation.
Now, as markets again priced for further rate cuts for 2025 despite rising money supply growth and rising inflation expectations, the P-star framework may offer crucial insights about the inflation risks ahead.
However, today’s situation differs from 2021 in important ways.
While monetary growth is accelerating, we start from a position of normalized velocity and much higher interest rates.
The key question is whether the Fed can maintain its post-2021 monetary discipline in the face of both market expectations for easing and mounting political pressure.
The P-star Model – A Monetary Approach to Inflation
The P-star model, introduced by Hallman, Porter, and Small in their seminal 1989 Federal Reserve paper, provides a framework for understanding inflation through monetary dynamics.
The model builds directly on the Equation of Exchange:
MV = PY
Where: M is the money supply (typically M2) V is the velocity of money P is the price level Y is real GDP
The key insight is that there exists an equilibrium price level (P*) determined by the money supply (M), the long-run equilibrium velocity of money (V*), and potential output (Y*):
Starting from MV = PY, and assuming V = V* and Y = Y*, we get:
P* = MV*/Y*
Where V* is calculated using an HP filter (λ=1600 for quarterly data) to smooth actual velocity, and Y* is the Congressional Budget Office’s estimate of potential real GDP.
The gap between actual prices (P) and the equilibrium price level (P*) – what I call the P-gap – provides a powerful indicator of future inflationary or deflationary pressures:
P-gap = (P* – P)/P*
A positive P-gap indicates prices need to increase to reach equilibrium, signaling inflationary pressures ahead. A negative P-gap suggests prices need to decline to reach equilibrium, warning of deflationary pressures.
This framework captures a fundamental monetary truth: sustained inflation requires monetary accommodation.
While supply shocks and other factors can cause temporary price pressures, persistent inflation occurs when excess money creation allows these pressures to become embedded in the price level.
From 2021 Warning to Current Signals
In early 2021, the P-star model flashed a clear warning signal. Following unprecedented monetary expansion during the pandemic, the P-gap had turned sharply negative, indicating substantial inflationary pressures building in the system.
With M2 having grown by over 40% in just two years and velocity certain to normalize as the economy reopened, the model predicted significant inflation ahead – a prediction that proved remarkably accurate.
Today’s situation is more nuanced. The Fed’s cycle has helped close much of the inflationary gap that existed in 2021-22.
However, recent data suggests new pressures may be building. With M2 growth accelerating, our latest P-star calculations indicate the P-gap will start turning positive again in coming quarters unless the Fed maintains tight policy.
The key difference from 2021 is that we start from a position of normalized velocity and much higher interest rates. This means the immediate inflation risk is lower than in 2021.
However, continued M2 acceleration combined with already normalized velocity could quickly recreate inflationary pressures.
Our model suggests that while immediate inflation risks remain contained, the margin for Fed error has significantly narrowed.
With velocity normalized and M2 growth picking up, any premature easing could quickly reignite inflationary pressures. This creates a challenging backdrop for the Fed as markets price in continued rate cuts and political pressure for easier policy mounts.
The question now becomes whether Powell’s Fed will maintain its post-2021 discipline or risk repeating past mistakes. To answer this, we need to examine how monetary policy transmission varies across different regimes.
Regime Changes Matter – From Great Moderation to Great Anxiety
To understand current risks, we need to examine how monetary transmission varies across different policy regimes. Our regression analysis of the P-gap’s impact on inflation reveals a striking pattern across monetary history.
The graph below shows the regime-dummies for the coefficient of the P-gap in an inflation regression.
This essentially shows how strong the pass-through is from excessive money supply growth to inflation and that this clearly is regime dependent.
During periods of well-defined monetary rules – e.g. during the Bretton Woods period or the inflation targeting period – the pass-through is weaker than during periods of low credibility. This was the case in the 1970s, but was also the case during the monetary expansion in 2020-2022.
The strength of monetary transmission tends to increase during periods of fiscal dominance and regime uncertainty. This pattern makes the current Trump/Powell dynamic particularly concerning, as it echoes aspects of the Nixon/Burns era when monetary policy became subservient to fiscal priorities.
Initially, I believed we had returned to Great Moderation-style credibility. Bond markets still suggest this, with breakeven inflation rates relatively stable. However, three developments challenge this optimistic view:
First, consumer inflation expectations have jumped from 2.8% to 3.3% between November 2024 and January 2025. Unlike market-based measures, consumer expectations appear more sensitive to announced policy changes.
Second, Trump’s increasingly aggressive tariff proposals echo the supply-side shocks that complicated monetary policy in the 1970s. Nearly one-third of consumers now spontaneously mention tariffs as an inflation concern.
Third, our regression analysis shows monetary transmission has strengthened significantly (coefficient 0.24), suggesting policy mistakes could have larger effects than during the Great Moderation period.
These factors create an environment eerily reminiscent of the early 1970s, when policy credibility began eroding before markets fully recognized the regime change. The question now is whether Powell will maintain his post-2021 Volcker-like resolve or succumb to political pressure like Burns.
The stakes may be even higher today given larger debt levels and more integrated global financial markets. This brings us to the crucial question of fiscal versus monetary dominance.
The Looming Threat of Fiscal Dominance
The real risk to price stability may not come from monetary policy directly, but from a potential crisis of confidence in U.S. fiscal sustainability. The incoming administration’s proposal to eliminate federal income taxes in favor of tariff revenue (yes, Trump has indeed suggested this) creates a particularly dangerous dynamic in current monetary conditions.
Consider the potential chain reaction: Markets begin questioning the revenue adequacy of this fiscal shift, pushing bond yields higher. Rising yields increase debt service costs, worsening fiscal dynamics.
This could trigger a negative feedback loop where fiscal concerns drive yields higher, further straining government finances.
Under normal circumstances, such concerns might force fiscal adjustment. However, the combination of strong monetary transmission (P-gap coefficient 0.24), normalized velocity, and rising inflation expectations creates a precarious situation.
Any hint that the Fed might cap yields through renewed QE could trigger a rapid shift in inflation expectations.
The risk scenario isn’t just about fiscal deficits – markets have tolerated large deficits before. The key danger is a sudden loss of confidence in the eventual normalization of U.S. fiscal policy.
If investors begin questioning whether there’s any path to fiscal sustainability, the pressure on monetary policy could become intense.
Unlike the 1970s or even 2021, today’s globally integrated bond markets could amplify any loss of confidence. With foreign investors holding significant U.S. debt, a shift in sentiment could trigger rapid portfolio adjustments, forcing the Fed to choose between defending price stability and maintaining financial stability.
This scenario would put Powell’s commitment to price stability under severe test – far more challenging than the inflation fight of 2022-23. The combination of fiscal dominance and strong monetary transmission could create inflation dynamics more powerful than anything seen since the 1970s.
Watch the P-gap, But Fear Regime Change
The updated P-star model does not, in itself, signal an imminent inflation surge like it did in 2021.
However, with M2 growth accelerating and velocity normalized, the P-gap projections suggest the Fed should be contemplating tighter, not looser, policy in the quarters ahead.
This technical conclusion puts the Fed on a collision course with both market expectations and political pressures.
While Powell has demonstrated more Volcker-like resolve since learning from his 2021 mistake, the real test may come from the bond market rather than direct political pressure.
The crucial risk is not just inflation itself, but a potential shift in market confidence about U.S. monetary-fiscal coordination. If investors begin questioning the long-term framework for price stability and fiscal sustainability, we could see a rapid shift from Great Moderation-style dynamics to something more reminiscent of the 1970s.
The current mix of:
- Strengthened monetary transmission
- Rising inflation expectations
- Tariff threats
- Radical fiscal proposals
- Normalized velocity
Creates an environment where policy mistakes could have outsized effects on inflation. While the P-star model suggests these pressures are still containable, the Fed has very little room for error.
Markets may be underestimating both the Fed’s resolve and the risks from fiscal-monetary interactions.
The lesson from 2021 was that monetary forces matter more than commonly assumed. The lesson from the 1970s was that once policy credibility erodes, regaining it becomes extremely costly.
Powell needs to thread a very narrow needle in 2025.
The P-star model suggests he should resist premature easing. History suggests he should fear regime change above all. Markets suggest he has a difficult job ahead.