Markets May Need to Confront a 3% Inflation Reality

Executive Summary

U.S. inflation has hovered near 3% for more than two years, suggesting the economy may have settled into a new equilibrium that is inconsistent with the Federal Reserve’s 2% target. At the same time, long-term inflation expectations embedded in Treasury markets remain closer to 2%, creating a tension that cannot persist indefinitely.

The New Inflation Stalemate

For more than two years, U.S. inflation has defied expectations. Despite one of the most aggressive tightening cycles in decades, price growth has settled into a stubborn holding pattern around 3%—neither accelerating nor falling back toward the Federal Reserve’s 2% target. Yet bond markets continue to price long-term inflation expectations close to 2%, creating a widening gap between realized inflation and what investors assume is the long-run equilibrium.

That combination—stable inflation and stable unemployment—is textbook u-star, the natural rate of unemployment consistent with non-accelerating inflation. The twist this cycle is that inflation appears stable not at 2%, but closer to 3%. Still, market-based inflation expectations embedded in long-dated Treasury yields—the so-called inflation break-evens—remain anchored near 2%, a disconnect that is becoming harder to justify as time passes.

Policy dynamics are reinforcing that tension. By pressing for a more accommodative rate environment, the Trump administration has made a clean return to 2% inflation increasingly unlikely. At the same time, recession risk—the historical reset button for inflation psychology—is fading rather than rising. Without a downturn, the forces needed to re-anchor expectations are largely absent.

Markets Are Starting to Notice

Inflation expectations in markets are often modeled by projecting recent inflation forward to an assumed equilibrium rate. For years, that equilibrium defaulted to 2% because it matched the Federal Reserve’s stated target. Recently, however, implied equilibrium inflation has begun to edge higher, suggesting expectations may be slowly un-anchoring.

The implications are already filtering through asset allocation decisions. With both U.S. Treasuries and Japanese government bonds facing upward pressure on yields, duration risk looks increasingly unattractive. In relative terms, investors are finding better value in German bunds and U.K. gilts, where inflation repricing risk appears less acute than in U.S. Treasuries and JGBs.

Quantitatively, the tension is clear: core inflation has hovered near 3% since early 2023, while 10-year U.S. inflation break-evens have struggled to move much above the low-2% range. The longer that gap persists, the greater the risk that break-evens recalibrate higher to reflect a de facto new equilibrium.

Do Higher Yields Hurt Stocks? It Depends

Whether rising bond yields are bearish for equities depends on which component of yields is moving. If yields rise because real rates spike—tightening financial conditions—stocks are vulnerable. But if the move is driven by higher inflation expectations, equities may be better positioned to absorb it.

Stocks are real assets. Higher inflation expectations imply stronger nominal growth in future cash flows, which can offset the impact of a higher nominal discount rate. As long as inflation expectations adjust gradually from 2% toward 3—and do not spiral higher as they did in the 1970s—the repricing need not trigger a violent equity selloff.

Recent market behavior reinforces this distinction. In recent months, changes in short-term real interest rates—not long-term nominal yields—have been the dominant driver of equity performance. The November bout of volatility, for example, was largely explained by the Fed’s hawkish pivot and subsequent re-pivot, underscoring how sensitive stocks remain to real-rate expectations rather than headline yields.

A world of stable 3% inflation represents a structural shift for markets. If real rates continue to ease—either through policy accommodation or higher short-term inflation expectations—equities may remain supported even as nominal yields grind higher. For investors, the challenge is no longer fighting inflation’s return, but adapting portfolios to its persistence—and the possibility that markets are slowly learning to live with a higher inflation norm.

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