Trump's testimony causes fluctuations in inflation expectations.

As Trump plans to testify on Foreign exchange market makers transactionsCapitol Hill this week and the highly anticipated January Consumer Price Index (CPI) release looms, Wall Street is increasingly focused on the future path of U.S. inflation. Of particular note are two important recent inflation expectation surveys from the University of Michigan and the Federal Reserve Bank of New York, which show an unusual and significant divergence, prompting market questions about which survey better reflects reality.

First, the University of Michigan's consumer sentiment index report was surprising. Last Friday, it showed consumer sentiment unexpectedly hit a seven-month low, while short-term inflation expectations surged. Notably, consumer expectations for inflation in the coming year jumped from 3.3% to 4.3%, rattling the markets, with bond traders even anticipating that the Federal Reserve might only cut rates once by 2025. Additionally, in this survey, Democratic supporters expected inflation over the next year to spike to 5.1%, while Republican supporters predicted it would drop to 0%.

However, on Monday, the New York Fed's survey indicated that while consumer expectations for inflation over the next five years rose to 3%, the expectations for the next year's inflation remained stable at 3%. This is relatively moderate and aligns with data since May 2024. Despite this, the significant differences between the University of Michigan and New York Fed survey results continue to perplex the market.

Some analysts believe the University of Michigan’s results may be influenced by political factors, particularly the extreme divide between the two parties. In this survey, the gap in inflation expectations between Democrats and Republicans is evident. Democrats think Trump administration policies will lead to inflation spiraling out of control, while Republicans believe Trump can contain inflation, potentially outperforming Biden's administration.

However, the New York Fed's survey is not entirely "flawless" either. The data shows that respondents' expectations for price increases over the next year for various goods, including gasoline, food, and healthcare, are rising, with growing disparities between different groups. Especially against the backdrop of Trump's proposed new tariffs on trading partners, market concerns about future price hikes are intensifying.

Current bond market data also suggests short-term inflation expectations are still higher than long-term ones, with this gap reaching its largest value in two years. Changes in the breakeven inflation rate reflect market concerns about short-term price shocks, particularly if Trump's trade policies trigger renewed inflation. Despite this, Deutsche Bank strategists say tariff-driven price shocks might not alter long-term inflation expectations.

A series of uncertainties are further complicating market sentiment. Apollo Global Management's chief economist, Torsten Sløk, warns that a full-blown trade war could lead to stagflation in the U.S. Meanwhile, EY's chief economist, Greg Daco, expects that if Trump's tariffs take effect, U.S. GDP could shrink by 1.5% in 2025 and 2.1% in 2026, with a 0.7% increase in first-quarter inflation.

As January's CPI release approaches, divergent inflation expectations may intensify, with investors closely monitoring the imminent data and subsequent policy directions of the Trump administration.

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