Tariffs and the Term Structure of Inflation Expectations

Inflation expectations derived from financial markets exhibited unprecedented dynamics in 2025: the correlation between one-year inflation swaps and one-year-ahead one-year forward rates turned significantly negative for the first time on record. We show that this decoupling occurred primarily on days when tariff news dominated market pricing, using a two-stage event classification validated by Bloomberg news trends. Standard small open-economy New Keynesian models in which tariffs generate a one-time price-level increase imply positive comovement across horizons and cannot explain this pattern.
We explain these occurrences through the lens of an amended small open-economy New Keynesian model. Three ingredients prove critical for reproducing the observed negative conditional correlation between spot and forward inflation after tariff shocks: targeting year-on-year inflation, substantial interest-rate inertia, and persistent tariffs. Under empirically plausible calibrations, the model generates a negative correlation conditional on tariff shocks while preserving a positive unconditional correlation, suggesting that the 2025 twist in the term structure reflects expectations of a persistent policy response to trade shocks.