The market’s decided that tariffs ≠ recession anymore

There are many ways to say “markets are pricing out recession risk and pricing in a continuation of the AI boom.”

Today, Nvidia is enjoying a healthy gain while the S&P 500 has a relatively run-of-the-mill decline following some fresh tariff tape bombs that sent futures lower on Thursday evening into Friday morning. That’s one way to say it.

Another way would be to look at the market’s pricing of inflation risk over the coming 24 months, and how that’s evolved since tariffs started to become a front-burner issue.

In the run-up to and immediate aftermath of Liberation Day, traders were pricing in tariffs as a front-loaded shock to prices that would push up near-term inflation while also pushing down inflation 12 to 24 months down the road.

The way to rationalize this, which was very much corroborated by the price action in equities at the time, was that tariffs were increasing recession risk: consumers were going to face a big purchasing power shock, be able to buy less, and that would prompt layoffs. Then inflation would decelerate, since corporate pricing power would go down with fewer people having jobs and able to buy things.

Something different has been happening lately. As one-year CPI inflation swaps have been moving higher lately, so too have the one-year, one-year forwards:

(That 2.5% one-year, one-year forward rate is roughly consistent with 2% PCE inflation — that is, consistent with the Federal Reserve’s target.)

Putting that together with stocks near all-time highs, the market’s judgement at this time appears to be that tariffs will propel inflation higher and there won’t be much economic pain as a result.

This shift in market pricing is also occurring amid an evolution in how Federal Reserve officials are thinking about the inflationary impact of tariffs. At his March press conference following a rate decision, Fed Chair Jerome Powell said it was “kind of the base case” that tariffs would spark one-off inflationary pressures (or transitory ones, if you prefer. No one will prefer.)

The release of minutes from the Federal Reserve’s June meeting this week showed that “a few participants” thought tariffs would lead to just a one-time increase in prices and not be a big deal for inflation expectations, but “most participants noted the risk that tariffs could have more persistent effects on inflation.”