The Return of the Expectations Trap
Lessons from the 1970s and Implications for 2025
Firstly, I want to acknowledge the ever insightful Danny Dayan (@DannyDayan5) for sharing the paper which catalyzed this post: “The Expectations Trap Hypothesis” by Lawrence J. Christiano & Christopher J. Gust
I subscribe to Macro Musings by Danny D and highly recommend it. Not just for the timely and data-driven notes Danny publishes, but also the trading room environment which has evolved within his daily “chat” post. It’s where you’ll find me hanging out most days, exchanging views etc. during trading hours.
What caused inflation in the 1970s?
The 1970s inflation wasn’t just a product of reckless money printing — it was the result of the Federal Reserve becoming ensnared in an “expectations trap.” In this trap, inflation expectations took on a life of their own, and the Fed, fearing recession and financial instability, accommodated those expectations rather than resisting them. This dynamic created a self-reinforcing cycle of inflation, despite policymakers’ stated intentions.
The key distinction in the paper is between two theories of why inflation got out of control:
• Phillips Curve Hypothesis: The Fed knowingly allowed inflation to rise in order to juice the economy and reduce unemployment.
• Expectations Trap Hypothesis (favored by the authors): The Fed had no desire for inflation, but was forced into validating rising expectations by its unwillingness to tolerate the short-term pain required to fight them.
In their model — specifically a limited participation framework — the Fed’s aversion to high interest rates (which would hurt investment and output via working capital constraints) created a dynamic where even a small inflation shock, if left unchecked, could spiral into a decade-long inflationary regime.
Why This Matters in March 2025
We’re seeing troubling signs that mirror the prelude to the 1970s trap — not just economically, but institutionally and psychologically.
1. Inflation Expectations Are Becoming Unanchored Again
Headline inflation prints have cooled, but longer-term inflation expectations — particularly in wage negotiations, input costs, and forward rate markets — remain sticky. Investors and businesses increasingly believe inflation will persist above target, and are acting accordingly. This is how the trap begins: beliefs start driving policy, not data.
2. The Fed’s Credibility Is at Risk
Policy signaling has become erratic. The central bank’s Summary of Economic Projections paints a hawkish path, but public commentary from Fed officials often walks it back. Markets are pricing in cuts faster than the Fed wants — and instead of pushing back, the Fed has often accommodated those views. This is the same credibility erosion that occurred under Arthur Burns in the early ‘70s: a central bank that’s perceived as afraid to tighten into weakness loses its anchor.
3. Term Premium Expansion = Modern Signal of Inflation Risk
Over the past six months (but not so much the last 3 months), long-end yields have risen notably, not due to stronger growth or inflation prints, but because of rising risk premia. Investors are demanding more compensation to hold duration in a regime where inflation uncertainty, fiscal deficits, and global capital flows are all in flux.
That’s textbook expectations-trap behavior: a Fed unwilling to fully normalize financial conditions has left long-term inflation risk to be priced in by markets. The result is a steepening curve, elevated real yields, and stress on rate-sensitive assets — even before any real economic deterioration sets in.
How the Trap Plays Out Today
We are in a phase where:
• Unemployment remains low, but the labor market is softening.
• Inflation is decelerating, but not fast enough to meet targets.
• Growth is stable, but not strong enough to withstand aggressive policy tightening.
This is exactly the environment where policymakers start blinking. If the Fed backs off tightening too soon — or worse, cuts preemptively to cushion modest job losses — they risk confirming the market’s view that they will not tolerate any short-term pain. That’s the inflection point where expectations can break away from fundamentals.
And unlike the ’70s, we now have:
• Exploding fiscal deficits
• Massive Treasury issuance with questionable demand
• A financial system more sensitive to liquidity conditions
The setup is volatile.
Investment Implications
1. Duration Vol Still Has Room to Run
Term premium is likely to remain elevated or rise further if Treasury continues to extend maturity issuance or if the Fed signals dovishness into sticky inflation. Long bonds may be pressured, and curve steepeners still offer asymmetric upside.
2. Sticky Real Rates = Headwind for Risk Assets
With elevated real yields and weak forward guidance, equities are vulnerable. Markets have yet to fully price in a stagflationary macro where growth stagnates but inflation remains persistent.
3. Repricing of the Fed Reaction Function
The market has priced in a series of cuts, assuming the Fed will act aggressively at the first sign of labor market weakness. If that view is correct, inflation expectations may spiral — bullish for hard assets like gold and energy. But if the Fed surprises to the upside on hikes or QT acceleration, risk assets could reprice sharply lower.
4. Watch QT Mechanics
Quantitative tightening has been muted over the past year by Treasury issuance patterns. If that changes — for example, if Treasury starts “terming out” debt and issuing more duration into a market already saturated — the liquidity drain could be abrupt. This would finally trigger the tightening impulse markets have largely ignored.
Bottom Line
The expectations trap is not a relic — it’s a live risk. The institutional weakness, fiscal fragility, and political pressures that led to runaway inflation in the 1970s are increasingly relevant in 2025. The Fed may not want to validate higher inflation, but if it lacks the will to hold the line when things get tough, markets will force their hand anyway.
This is a regime where asymmetric trades and discipline matter most:
• Favor tactical long STIR vs. short equities setups
• Keep dry powder for spikes in volatility
• Watch forward inflation and rate expectations more closely than realized data
As ever, we think in probabilities. The trap isn’t guaranteed — but the conditions for it are quietly falling into place.
Actionable Takeaways for Traders:
Monitor Inflation Expectations, Not Just CPI Prints
Market-based breakevens, inflation swaps, and wage data are forward-looking clues to potential expectation-driven inflation.
Watch Treasury Behavior at Next QRA
Terming out debt (moving from bills to bonds) could finally unmute QT — triggering real tightening via term premium expansion.
Be Wary of Fed Dovish Pivots on Employment Softening
That’s how an expectations trap begins. A central bank that appears to abandon inflation control triggers real consequences — regardless of their intent.
Favor Asymmetric Trades in STIR and Duration
Long STIR (e.g., SFRM6) vs. short equities or curve steepeners make sense under rising term premium + inflation repricing conditions.
Hedge for Sticky Inflation + Growth Shock
The stagflation scenario of the 1970s wasn’t predicted by models expecting a typical boom-bust cycle. Gold, commodities, and short equities were the trade then — and may be again.
Appreciate the pushback, both of you — sharp points.
@Bob Totally agree that commodities were a major transmission vector in the ’70s. My focus in this piece was more upstream: why the Fed tolerated inflation even as those shocks hit. The trap wasn’t just oil — it was the Fed’s institutional reluctance to fight back once expectations re-anchored higher.
On fiscal vs. monetary: you’re right that the fiscal impulse is doing the heavy lifting now — and arguably rendering rate hikes less effective via the “income channel” (especially among higher net worth cohorts). This is a real divergence from prior cycles. But I’d argue that monetary impotence is precisely what makes the expectations trap so dangerous today.
As for real rates — I agree they’ve only recently turned positive (depending on your inflation input). But that’s kind of the point: if inflation expectations become unanchored before real rates go positive, it forces the Fed to tighten into weakness or lose control of the narrative. That’s the trap.
Totally with you on gold and YCC. If wave 2 of the commodity cycle hits, and we’ve got structurally large deficits + rising geopolitics + reshoring — the pressure to “accommodate” is going to mount fast. They’ll choose inflation is a great line.
@Yessir — that’s a great addition. The credit channel hasn’t been driving the inflation this cycle, unlike the ’70s. Which makes the stickiness of services and wage inflation even more concerning — this isn’t credit-fueled. It’s structural. That’s arguably more dangerous in the long run, because it’s less rate-sensitive.
Thanks again to both of you. This is the kind of debate that sharpens edges.
Good read, but missing the commodities cycle as an explanatory factor for the 70s. I think you're also exaggerating the power the Fed has to control inflation too. Fiscal is in the driving seat - Fed is largely powerless and paralyzed here. In fact - higher rates has actually proved quite stimulatory to the higher income cohorts through their savings.
I don't think real rates were even positive until mayberecently - gold is telling you that. Using the old CPI metrics, real rates certainly weren't positive even when the Fed thought they were max tight.
Waiting for wave 2 of the secular commodities bull market to hit - then we'll really see whether the appetite for much higher nominal yields is there or not. They'll choose inflation, they always do. Some for of YCC