Inflation, Stagflation, or Deflation?
We receive research from around the world, and what stands out is the wide divergence in current market expectations. The outlook for oil prices alone illustrates this clearly.
Morgan Stanley argues that, following the reopening of the Strait of Hormuz, the oil market could move into surplus, putting further downward pressure on prices. Goldman Sachs, by contrast, expects oil prices to remain broadly in line with current levels for the time being. Other analysts, however, anticipate a significant increase in oil prices as global economic activity strengthens and inventories are rebuilt, reflecting the growing recognition of the vulnerability of key supply routes.
The outlook for the broader economy is equally divided. Some economists expect AI to advance rapidly, driving a substantial increase in productivity. In their view, this could lead to higher unemployment and ultimately result in deflation. Others foresee a variation of this scenario, combining rapid AI adoption with higher oil prices, leading to stagflation—a combination of elevated inflation and weak economic growth.
Another group of economists expects the Federal Reserve, under pressure from the White House, to maintain relatively low interest rates. Combined with the ongoing wave of AI-related investment, this could keep economic growth robust while creating labour shortages. As a result, they expect stronger wage growth and rising inflation.
It is interesting to consider how financial markets are currently pricing these competing scenarios. Four key market indicators provide valuable insight.
Gold
The performance of gold prices suggests that, from mid-2025 onwards, investors expected central banks—particularly the Federal Reserve—to pursue an overly accommodative monetary policy. At the same time, markets anticipated a period of strong economic growth accompanied by rising inflation. This expectation was partly driven by the belief that the new Fed Chair, Kevin Warsh, would favour lower interest rates.
The Yield Curve
That narrative began to shift in May this year, when Warsh officially took office and made several public statements. The question now is whether the gold market has begun to price in a scenario of relatively high interest rates combined with deflation.
If that proves to be the case, short-term interest rates would be expected to rise, while long-term rates would increase more slowly or potentially even decline. Although the spread between the U.S. two-year and ten-year Treasury yields has narrowed, the yield curve has not yet inverted. Such an inversion would typically signal that markets are anticipating a recession.
The U.S. Dollar
The U.S. dollar also provides important signals. A useful measure is the U.S. Dollar Index (DXY), which tracks the dollar against a basket of major currencies. The index reached a low at the end of January and has risen overall since then.
This points to an economy that continues to outperform its peers, with inflation remaining under upward pressure due to higher oil prices and/or stronger wage growth. In such an environment, the Federal Reserve would normally respond by raising interest rates. As with the gold market, however, the question remains whether higher rates could ultimately trigger a recession and lead to deflation.
Equities
Equity markets suggest that investors may have feared an excessive slowdown in economic growth until the end of March. Since then, however, sentiment appears to have improved, with markets becoming increasingly optimistic about the economic outlook.
In summary, markets initially assumed that the Federal Reserve under Kevin Warsh would pursue an overly accommodative monetary policy, resulting in higher inflation. Since the beginning of this year, however, that view has evolved.
Markets now appear to expect the U.S. economy to continue growing at a healthy pace. While this is expected to put upward pressure on wages and inflation, investors believe the Federal Reserve will be able to tighten monetary policy without immediately triggering a recession. This view is further supported by the broadly positive expectations surrounding the economic impact of AI.
Our View
In our view, however, this assessment may be somewhat optimistic.
Over the longer term, AI is likely to deliver significant productivity gains, but this transformation will take time to spread across the economy. Productivity in manufacturing can increase relatively quickly through the adoption of robotics and AI, whereas productivity improvements in the services sector are likely to emerge much more gradually. As a result, we expect the labor market—particularly in the United States—to become so tight that wage growth and inflation will accelerate beyond desirable levels. This would likely require the Federal Reserve to tighten monetary policy more aggressively than is currently priced in by the markets.
In our view, such a scenario would, over time, be supportive of the U.S. dollar while weighing on gold and equity markets.
For our specific market forecasts, including the price levels we expect and the rationale behind them, please refer to our Global Financial Markets report. If you do not yet have access, Manufacturing accounts for roughly 20% of the economy, while services represent approximately 80%.
We therefore expect economic growth to remain relatively strong in the near term, supported by the ongoing AI investment boom and still-accommodative fiscal and monetary policies, even though economy-wide productivity gains are likely to materialise only gradually. As a result, we expect the labor market—particularly in the United States—to become so tight that wage growth and inflation will accelerate beyond desirable levels. This would likely require the Federal Reserve to tighten monetary policy more aggressively than is currently priced in by the markets.
In our view, such a scenario would, over time, be supportive of the U.S. dollar while weighing on gold and equity markets.
For our specific market forecasts, including the price levels we expect and the rationale behind them, please refer to our Global Financial Markets report. If you do not yet have access, you can request a complimentary introductory copy here (subject to approval).
