As we move through the final quarter of 2025, investors face a peculiar economic environment characterized by stark contrasts. The stock market continues to reach record highs even as underlying economic data paints a more nuanced picture—and warning signs suggest that our inflation challenges may be far from over.
The Economic Crosscurrents
The economy is sending decidedly mixed messages. Job creation has slowed dramatically to just 22,000 positions in August. Construction activity is weakening, manufacturing remains in contraction, and labor force participation continues to decline. Yet retail sales remain robust, household net worth jumped in the second quarter, and the Atlanta Fed forecasts solid 4.0% third-quarter GDP growth.
Why does GDP keep growing when many consumers don't feel it? The answer reveals what analysts call the "K-shaped economy." The AI boom exemplifies this perfectly: a handful of tech giants spend vast sums on chips and infrastructure, with money flowing to energy, industrial, and materials firms. Most Americans experience this primarily through higher consumer prices, not rising incomes.
Spending is increasingly concentrated among wealthier households. The top 10% of earners now account for nearly half of all consumer spending, up from about 36% three decades ago. Combined with financially stronger senior citizens—who comprise roughly 18% of the population and control a disproportionate share of spending—this creates an economy that can stay resilient even as average workers face headwinds.
The Third Wave: Why Inflation May Not Be Finished
If you remember 1970s inflation, you know it wasn't just a few bad years—it was an era spanning the mid-1960s through the early 1980s, coming in three distinct waves, until Fed Chair Paul Volcker finally ended it with extremely painful medicine: high interest rates, two recessions and elevated unemployment.
Looking at today's data, an unsettling pattern is possible. We're roughly four years into post-COVID inflationary pressure. Inflation peaked in 2022 but remains stuck above pre-pandemic rates at 2.9% (CPI) and 2.7% (PCE). Recent data shows the percentage of items experiencing 3% or greater price increases began rising again late last year.
It’s important to remember that inflation is a rate, not a level. A year of 5% inflation followed by 1% inflation still leaves prices 6% higher than two years earlier. Absent outright deflation—which brings its own problems— inflation represents a permanent increase in the overall price level.
Several forces suggest ongoing pressure. Housing costs, which carry the largest CPI weight, rose about 3.6% over the past year. If housing continues at this pace while other previously flat categories turn higher, another inflation “wave” becomes a meaningful risk rather than a remote possibility.
Fiscal Dominance: New Constraints on the Fed
The most significant (and less widely discussed) development is the emergence of "fiscal dominance," where monetary policy becomes heavily influenced by the government’s need to finance its debt rather than purely targeting inflation and employment.
The numbers are sobering: a roughly $2 trillion annual deficit representing about 7% of GDP—fiscal stimulus equivalent to ongoing quantitative easing. Even before counting interest costs, the U.S. is running a deficit around 4% of GDP in what should be relatively good economic times. National debt exceeds $38 trillion with annual interest costs approaching $1 trillion. Without meaningful deficit reduction, debt could reach $50 trillion by decade's end, with debt-to-GDP ratios moving significantly higher.
This puts the Federal Reserve in a difficult position. Many monetary models, such as the Taylor Rule, imply that rates “should” be higher than current levels. Yet political pressure often pushes toward lower rates, with some officials even advocating for a return to very low (or 1%) policy rates.
Ray Dalio describes the Fed's predicament as "easing into a bubble." Unlike the last quantitative easing era responding to weak GDP and low inflation, today we have solidly growing GDP and persistent inflation. Yet the Fed has cut rates 150 basis points, ended balance sheet reduction, and is actively injecting liquidity. As Dalio warns, "This looks like a bold and dangerous big bet on growth, especially AI growth, financed through very liberal looseness in fiscal policies, monetary policies, and regulatory policies."
The danger: if rate suppression combines with persistent deficit spending, the line between financing debt and monetizing it can blur. Historically, heavily indebted regimes have been tempted to let inflation erode the real value of their obligations. The challenge is that once inflation expectations reset higher, bringing them back down can be difficult and costly.
Markets and Fiscal Reality
The S&P 500 has gained about 13.4% year-to-date, reaching record highs on genuine earnings growth. Over long periods, stock returns have averaged around 10% annually—roughly 7-8% from earnings growth plus 2% from dividends. Current prices appear to reflect a lot of good news about growth and profitability.
However, 150 basis points of Fed rate cuts have done relatively little to lower long-term interest rates. That’s a signal that bond markets remain cautious about both inflation and fiscal sustainability.
The fiscal pressures extend beyond annual deficits. Social Security's trust fund is projected to face depletion in the early 2030s, which could require some combination of benefit adjustments or tax increases. Medicare faces similar long-term funding challenges. The recent "One Big Beautiful Bill Act," if made permanent, could add trillions more to projected deficits over the next decade.
The next Fed chair appointment will be critical. A future chair perceived as overly dovish could unsettle bond markets. The situation demands someone with strong inflation-fighting credentials, not a willingness to subordinate monetary policy to political convenience.
Investment Implications
In a world of mixed signals, it’s tempting to make big portfolio shifts. We think a more constructive approach is to update expectations and refine strategy rather than trying to time every macro development.
Maintain equity exposure—but manage expectations. Despite higher valuations, stocks have historically been the best long-term inflation hedge. However, expect 10% long-term averages rather than outsized recent gains. In a fiscal dominance scenario with suppressed rates and persistent inflation, hard assets and equities could outperform bonds.
Diversify. U.S. markets trade at premium valuations. Developed international and select emerging markets may offer better relative value and provide useful currency diversification if fiscal challenges persist at home.
Be thoughtful about traditional fixed income. If inflation remains somewhat elevated and fiscal pressures persist, long-duration government bonds could remain volatile. Some investors may want to emphasize shorter-maturity bonds, TIPS, and other fixed-income strategies that balance income needs with inflation and interest-rate risk.
Consider inflation hedges. Real assets, commodities, infrastructure and gold can play a role in a diversified portfolio. Central banks around the world have been notable buyers of gold in recent years—reflecting broader concerns about debt and currency stability.
Plan for the possibility of higher taxes and inflation. Given fiscal realities, tax changes over the next decade are a reasonable planning assumption. It can be wise to maximize tax-advantaged accounts, consider strategic Roth conversions before rates rise, and be mindful of how inflation can push investors into higher brackets over time (“bracket creep”).
Stay invested through volatility. Market corrections, even during economic expansions, are normal. Historically, stocks have often bottomed before recessions officially end, which makes precise market timing difficult. A rules-based rebalancing and risk-management process often works better than emotional decision-making.
A Time for Realism
We may be entering a period unlike anything most investors have experienced for quite some time. The combination of higher debt levels, fiscal dominance, and potential renewed inflation creates challenges the Fed can't solve by simply cutting rates. Solutions, whether from AI productivity gains, healthcare cost reductions, or structural reforms, will take at least a decade.
The more likely near-term scenario involves navigating a sovereign debt crisis forcing changes in healthcare, Social Security, taxes, and other economic fundamentals. This doesn’t necessarily mean markets are destined for crisis or collapse. Economies and markets can function—even adapt—in higher-debt, moderate-inflation environments. What it does mean is that old assumptions may need updating: about expected returns, interest rates, tax policy, and the role of different asset classes in a long-term plan.
In this setting, the most valuable tools are balance, discipline, and perspective:
Balanced portfolios that match your true risk capacity,
Realistic return expectations, and
The discipline to stick with a well-thought-out plan through inevitable bouts of volatility.
Bringing It Back to Your Plan
If recent economic signals have raised questions about your long-term strategy, we can help you review risk exposure, tax positioning, retirement planning milestones, and whether your investment approach remains aligned with your goals. Schedule an investment planning conversation with Aspire Planning Associates at (925) 938-2023.
