Rising Long-Run Inflation Expectations and Their Implications for Asset Allocation

The global economic landscape in 2025 is marked by a quiet but profound shift: inflation expectations are no longer a short-term anomaly but a structural feature of the market psyche. For investors, this reorientation demands a recalibration of asset allocation strategies. The evidence is mounting that both consumers and businesses are internalizing a new inflationary baseline, driven by divergent survey methodologies, political polarization, and policy-driven supply shocks. This article examines how these dynamics signal a long-term inflationary shift and why prioritizing inflation-protected assets and defensive equities is now a strategic imperative.

The Structural Shift in Inflation Expectations

Consumer inflation expectations, as measured by surveys like the University of Michigan's Surveys of Consumers (MSC) and the New York Fed's Survey of Consumer Expectations (SCE), have diverged sharply in 2025. A critical factor is the political composition of survey samples. For instance, the Daily Consumer Survey (DCS) and Indirect Consumer Inflation Expectations (ICIE) have seen a rise in Republican respondents, who historically report higher inflation expectations than Democrats. In April 2025, the MSC's average inflation expectations for Democrats exceeded those of Republicans by over 10 percentage points—a gap that narrowed when samples were reweighted to reflect broader population demographics. This politicization of inflation expectations underscores a broader societal realignment, where trust in institutions and policy narratives shape perceptions of economic stability.

Businesses, meanwhile, have tempered their inflation forecasts. The Atlanta Fed's Business Inflation Expectations (BIE) Survey reports that firms now anticipate 2.3% year-ahead inflation, down from earlier peaks. This moderation reflects stable unit cost growth and declining sales for large firms, but it masks deeper structural pressures. For example, the BIE includes a special question on trade policy impacts, revealing that tariffs and supply chain disruptions are still embedded in pricing decisions. These policies, while ostensibly aimed at reducing reliance on foreign goods, have introduced persistent cost shocks that businesses are likely to absorb or pass through to consumers.

Structural Economic Factors: Tariffs, Productivity, and Policy Uncertainty

The 2025 inflationary backdrop is not merely a function of expectations but of tangible economic shifts. Broad-based tariffs, for instance, are acting as a negative supply shock. By raising the cost of imported intermediate goods, these policies are expected to push core PCE inflation up by 0.7–1.2 percentage points in 2025. This is compounded by policy uncertainty surrounding immigration, regulation, and trade, which has dampened business and consumer confidence.

On the supply side, labor market dynamics are a double-edged sword. While labor force participation has rebounded—driven by immigration and AI-driven productivity gains—demographic headwinds and pandemic-related early retirements persist. Productivity growth, now averaging 2% annually (up from a historical 1.2%), has been a bright spot, fueled by automation and AI adoption. However, these gains are unevenly distributed, with sectors like information technology and retail benefiting most.

Monetary policy remains in a delicate balancing act. The Federal Reserve has maintained a cautiously accommodative stance, but the risk of inflation expectations becoming unanchored looms large. With long-term breakeven rates (a proxy for inflation expectations) trending upward, the Fed faces a trade-off between tightening too aggressively and allowing inflation to become entrenched.

Asset Allocation in a High-Inflation World

The implications for investors are clear: traditional diversification strategies are no longer sufficient. The 60/40 portfolio, once a cornerstone of risk management, has lost its luster as the negative correlation between equities and bonds erodes. Instead, a focus on inflation-protected assets and defensive equities is warranted.

1. Inflation-Linked Bonds: A Structural Hedge
Treasury Inflation-Protected Securities (TIPS) remain a critical tool for managing inflation risk. Historically, TIPS outperform nominal bonds when breakeven inflation rates align with or exceed realized inflation. For example, during the 2020–2022 inflation spike, TIPS delivered strong returns as central banks delayed rate hikes. However, investors must be mindful of interest rate sensitivity: rising rates can depress TIPS prices, even as inflation-adjusted income rises.

2. Defensive Equities: Beyond Sectoral Conventions
Defensive sectors like utilities and consumer staples have historically offered lower sensitivity to inflation. Yet, valuations matter. Consumer staples, trading at 21 times forward earnings (well above its historical average), are less attractive as value plays. In contrast, healthcare providers, trading at 13 times forward earnings (below their long-term average), offer a more compelling entry point. Low-volatility equities, which historically outperform during stagflationary periods, also deserve consideration.

3. Alternatives and Cash-Like Instruments
Gold, infrastructure, and cash-like alternatives (e.g., short-duration bonds) can complement traditional portfolios. Gold, in particular, has shown resilience during periods of policy uncertainty and inflation spikes. Infrastructure investments, with their stable cash flows and inflation-adjusted returns, are another avenue for diversification.

Conclusion: Preparing for the New Normal

The 2025 inflationary environment is defined by structural shifts in expectations, policy, and supply chains. While the immediate outlook may see temporary disinflationary pressures, the long-term risks of unanchored expectations and policy-driven cost shocks are real. Investors must prioritize assets that offer both inflation protection and resilience to macroeconomic volatility. TIPS, defensive equities, and alternative strategies are not just tactical choices—they are foundational to navigating a world where inflation is no longer a transient concern but a persistent reality.