A significant puzzle is emerging in global financial markets: the absence of US interest rate increases priced into futures contracts despite prevailing economic data. Core inflation in the United States, as measured by the Federal Reserve’s preferred metric, core PCE, appreciated by 3 per cent over the 12 months to February and a stronger 3.4 per cent on a six-month annualised basis. This indicates US inflation has been running over 50 per cent above the central bank’s mandated 2 per cent target even before recent surges in commodity prices. The Federal Reserve, the central bank of the United States, is responsible for conducting monetary policy to foster maximum employment and price stability. Its credibility is now under scrutiny as inflation has materially exceeded its target for over half a decade.
Adding to this complexity, the US economy continues to run hot. The jobless rate has fallen to 4.3 per cent, bolstered by substantial fiscal and monetary stimulus alongside a boom in artificial intelligence-related spending. New business incorporations surged by 20 per cent in 2026, illustrating robust entrepreneurial activity. Modelling suggests the normal, or neutral, Fed cash rate has climbed to approximately 3.75 per cent, up from 1.5 per cent in 2020. This implies the Fed should be considering rate increases, not cuts, to manage inflationary pressures, a stance only recently hinted at by the central bank after a period of market expectations for easing.
This disconnect poses a substantial threat to global equity valuations, which typically rise when the long-term risk-free cost of capital declines. US equity markets appear stretched, with the S&P 500 estimated to be about 40 per cent overvalued relative to its long-term trend. The one-year forward earnings-yield premium over inflation-adjusted government bond yields has collapsed to 2.8 per cent, its lowest level since the 2000-2001 tech wreck. Markets are therefore highly vulnerable to a significant shift in Fed policy towards tightening. In Australia, government spending has also contributed to inflation and the cost of living, with some $800 billion in extra debt accumulated since 2019.
