The biggest unwelcome development this year has been the persistence of inflationary pressures that policy makers had hoped would by now be history. We got more evidence of that on Friday when the consumer sentiment report showed a ten-point drop on the back of higher expected inflation rates.  

This is an awkward situation for a Federal Reserve that had previously been hoping to cut interest rates. But after the U-turn in CPI, markets have largely given up on rate cuts, at least in the near term. In fact, speaking to CNBC on Friday, Fed official Neel Kashkari said another rate hike can't be ruled out.  

So why is inflation proving so difficult to tamp down? The fault, perhaps, lies not so much with the Fed as with officials across town. The government is running a budget deficit of roughly 7% of GDP--what we used to see in recessions, not in bull markets. The more the Fed hikes rates, the worse the deficit gets, thanks to higher interest payments. But if they ease prematurely, inflation remains sticky, which is also driving the deficit wider through higher government spending.   

The ugly deficit situation is the single biggest economic risk on the horizon. Recall we were running just a 1% deficit before the financial crisis, which then exploded to nearly 10% when the economy tanked, revenues evaporated, and the Obama administration began large fiscal stimulus programs in 2009. If we are running a 7% deficit now...where does that leave us in the next downturn?  

The problem, as Jason Trennert of Strategas put it on Friday, is that "there are only three options when you have deficits of this magnitude." You can (1) structurally fix them by cutting government spending, increasing taxes, or both; (2) accept higher interest rates (and inflation) as a fact of life; or (3) hope you get lucky and that real economic growth surprises to the upside thanks to innovations like AI, Ozempic, and so forth. 

The third option looks unlikely in the near term, he noted, and the first one is unlikely politically--especially in an election year. "So as a result, I think you want to count on stickier inflation and higher long-term interest rates," he told us. Especially because the higher the Fed keeps rates to fight inflation, the wider that drives the deficit: interest on the debt is already larger than Medicare, Medicaid, and Defense and has already soared 42% year-on-year.  

The problem is that as sticky inflation expectations become entrenched in markets, investors are going to be less and less inclined to own Treasury debt, driving interest payments yet higher. It becomes a vicious negative feedback loop: higher deficits --> higher inflation --> higher interest rates --> higher deficits.  

"We suspect the third Fed mandate--low and stable Treasury rates--played a role in the December pivot and bias to ease despite hotter than expected 1Q24 inflation," wrote Barry Knapp of Ironsides Macro over the weekend. He added that last week's price action in markets "was a microcosm of the higher inflation regime: equities are higher, but buyers of the 10-year auction lost money."  

And investors are unlikely to want to snap up long-term Treasuries again until the economy slows meaningfully, assuming there will be no structural fix as of yet to bringing down the deficit. But the problem even in that case is that recessions also tank government revenues (as we saw in 2008-09), so the budget deficit will still widen significantly! 

Higher inflation, higher interest rates, and a slowing economy is an unpleasant prospect that more and more investors are starting to contemplate.  

See you at 1 p.m...

Kelly 

Click HERE to sign up for this newsletter in one easy step.

To hear this as a podcast, subscribe to "The Exchange" and pick "From the desk of..." 

Twitter: @KellyCNBC

Instagram: @realkellyevans