The Caladan Weekly | The Impossible Economy: America’s Policy Paradox

The Game Has Changed

The American economy stands at an extraordinary crossroads where traditional economic relationships are breaking down.

The Federal Reserve has adopted a hawkish policy framework while implementing dovish actions, confronting structural inflationary pressures that monetary policy cannot address. Tariffs impose an average tax increase of $1,300 per household, while inflation expectations have reached 4.9% for the year ahead, the highest since 1993.

We’re entering the “monpolvol” era, where monetary policy volatility creates whipsawing market reactions. Most tellingly, 62% of Americans expect unemployment to rise, a level of pessimism that has preceded actual unemployment surges in every single instance.

The Powell Paradox

This breakdown of traditional relationships creates impossible choices for policymakers. Jerome Powell’s Jackson Hole speech just last week embodied a fundamental contradiction. The Fed abandoned its flexible average inflation targeting framework, returning to orthodox balance between employment and price stability. The Fed removed “shortfalls” language, eliminated lower bound considerations, and abandoned commitment to overshooting inflation targets. These represent a hawkish shift in the reaction function.

Yet Powell delivered this framework revolution with dovish implementation guidance. This paradox reflects deeper tension: the Fed recognizes the need for a disciplined framework to maintain credibility but faces immediate pressures demanding accommodation.

July’s FOMC meeting witnessed the first double-governor dissent since 1993, with Bowman and Waller voting for cuts against the majority. September could see up to seven dissents, representing unprecedented institutional fracture. Political pressure intensifies: Trump has called for 3 percentage points of cuts, while Treasury Secretary Bessent noted any reasonable model would justify rates 1.5 percentage points lower.

Powell has only six meetings remaining. The real trouble comes in Q1 2026 when, after 50 basis points of cuts, growth remains strong and cyclical inflation reaccelerates, yet board members are even more dovish, creating conditions for bond vigilante dynamics.

The Tariff Trap

These institutional fractures extend beyond monetary policy to trade dynamics that compound the Fed’s impossible position. Current tariffs affect 30% of U.S. imports at a 27% average rate, the highest since 1903. Penn Wharton estimates suggest tariffs could reduce GDP by 8% and wages by 7%, creating stagflationary pressures. We’re only one-third through the economic digestion process, with peak impacts in 2026.

This creates dangerous convergence where fiscal stimulus arrives as tariff impact materializes, meeting an ultra-dovish Fed. General Motors absorbed $1.1 billion in tariff costs in Q1 2025 alone, protecting consumers temporarily but compressing margins unsustainably.

The Fed faces a decision matrix with no good options. If producers absorb costs, margins compress and layoffs follow. If consumers bear costs and demand higher wages, wage-price spirals emerge. If consumers pay but lack bargaining power, demand collapses. Research from the New York Fed documented significant manufacturing job losses during the first Trump trade war, and current indicators suggest even greater losses lie ahead.

Price impacts are materializing: apparel up 17%, vehicles cost $4,000 more, fresh produce up 4.0%. These regressive impacts hit lower-income households hardest.

The Three-Mandate Reality

The tariff trap interacts with deeper structural problems in how the Fed operates. The Fed operates under an impossible trinity: price stability, full employment, and financial stability. Each pulls policy in different directions. Market consensus concludes the Fed will run the economy hot, accepting above-target inflation to support employment and asset prices.

This creates an investment regime where assets performing well in inflationary environments without hawkish reactions become optimal. Traditional valuation strategies have failed since 2008. Equity markets reflect K-shaped reality, with the top 20% of earners driving over half of consumption.

The 62% expecting unemployment to rise represents more than sentiment, it’s a leading indicator that has perfectly predicted increases historically. For the first time, the top 33% of income households are more pessimistic than middle and bottom thirds, signaling recognition of structural challenges.

July added only 73,000 jobs versus 100,000 expected, with 258,000 downward revisions. The mean perceived probability of job loss increased to 14.4%, typically associated with recession conditions.

Market Structure Evolution

These labor market dynamics are amplified by fundamental changes in how markets themselves function.

As aforementioned, we’ve entered “monpolvol” where extreme data dependency creates violent pricing swings. Systematic strategies dominate: risk parity funds, volatility algorithms, passive flows creating procyclical amplification turning minor surprises into major moves.

SOFR futures have become essentially untradable. September cuts are 87-90% priced, but Powell’s exit and dovish board create significant volatility risk. Inflation breakevens have widened despite dovish expectations, suggesting markets price persistently higher inflation regardless of policy.

Traditional transmission mechanisms are breaking. Growing stablecoin demand creates structural dollar bid keeping currency elevated despite dovish policy. Digital assets benefit from both dollar strength and dovish policy simultaneously, a combination traditional frameworks consider impossible.

2026 Convergence

The breakdown in market transmission mechanisms points toward a critical timing problem that could trigger the next crisis. Fiscal and monetary policy interaction creates critical timing mismatch. The tariff tax hits immediately while stimulus won’t arrive until 2026. This forces the Fed to either ease aggressively now, risking overshooting when stimulus arrives, or maintain restraint and risk unnecessary weakness.

The 2026 convergence creates perfect storm conditions. Fiscal stimulus arrives as tariff impacts peak, meeting ultra-dovish Fed under new leadership confronting inflationary consequences. This could trigger shifts from disinflationary concerns to inflationary panic, bringing back bond vigilante dynamics.

Markets expect explicit fiscal-monetary coordination to manage debt through financial repression, with negative real rates systematically inflating away the burden. This represents regime change from independent monetary policy to fiscal dominance.

Consumer Psychology and Navigation

This potential regime change from independent monetary policy to fiscal dominance is already visible in shifting consumer behavior and expectations. Consumer sentiment collapsed to 58.60 in August, with expectations below 80 for six consecutive months, historically signaling recession. Long-term inflation expectations at 4.1% for 5-10 years represent the highest since February 1993, suggesting psychological reprogramming for permanently higher inflation.

Half of Americans are delaying discretionary purchases, creating self-fulfilling slowdowns. The wealth effect sustaining consumption becomes vulnerable as affluent confidence wavers. The convergence makes traditional analysis misleading. Policy reaction functions have become endogenous to market expectations, creating recursive loops where Fed actions depend on market reactions which depend on Fed actions.

The K-shaped economy breaks aggregate statistics. GDP growth can coincide with widespread distress. Asset prices can appreciate while living standards decline for the majority. Inflation can be simultaneously too high for workers and too low for debt sustainability.

Navigating requires acknowledging several realities: tariff cycle one-third complete and accelerating; Powell’s final meetings guaranteed dovish; K-shaped economy becoming structural; inflation expectations permanently unmoored; labor psychology in recession-mode despite strong conditions; fiscal stimulus arriving as tariff impacts peak; political capture of monetary policy explicit.

Traditional frameworks have become dangerous. When valuation strategies haven’t worked for fifteen years, when sophisticated participants declare markets untradable, conventional approaches must be abandoned. The new framework must acknowledge that policy tools designed for twentieth-century industrial economies cannot address twenty-first-century post-industrial challenges, different segments experience different realities simultaneously, and nominal returns may appear attractive while real purchasing power erodes dramatically.