by Steve Blumenthal (Thanks Per Andelius)
In his 1970 lecture, Milton Friedman advocated a “k-percent rule,” in which the money supply should grow at a fixed, predictable rate each year to allow for natural economic growth without inflation.
Dr. Lacy Hunt has pivoted from believing that rates will decline to being concerned that inflation and interest rates are heading higher. The word concerned is an understatement.
His current alarm stems from the Fed’s abandonment of this “stable rule” mindset. In his SIC presentation this week, Lacy noted that since mid-December 2025, bank credit and “Other Deposit Liabilities” (ODL) have exploded, growing at double their historic growth rates, which is a direct violation of the stability that Friedman championed in his “Counter-Revolution.” See the Friedman video here.
Friedman’s primary conclusion was that the “invisible hand” is more effective than state intervention and that the private sector is inherently stable if the state simply controls the money supply. By abandoning this control in late 2025, Lacy argues the Fed has introduced “chaos” into what should be a self-correcting system.
Dr. Lacy Hunt’s presentation at the 2026 Strategic Investment Conference marks a significant pivot in his long-held economic thesis. Lacy is an economic legend. I’m a big fan and read his missives when he posts.
Lacy’s been bullish on bonds for as long as I can remember. I’ve been bearish on bonds, having written about a generational low in bonds back in the spring of 2020. The end of the long-term debt cycle and the likelihood that the Fed will print, print, and print even more. We’ve witnessed just that, and I believe it will continue. His investment strategy is simple: his firm invests in long-term Treasury bonds or moves 100% into short-duration Treasury Bills. He admits in his presentation that he was wrong. For the reasons outlined below, he is not 100% invested in T-Bills.
Why? Lacy argues that the U.S. is currently caught in a rare and dangerous “double shock”: a massive, unrecognized liquidity impulse from the Federal Reserve colliding with a major global oil supply disruption.
The following summary explores his analysis of these two forces, why he believes they have fundamentally changed the trajectory of inflation, and his surprising new outlook for the direction of interest rates.
A Dual-Front Crisis
- Lacy sees two powerful inflationary engines that were sparked in late 2025 and early 2026
- Fed Error: He pointed to a major “policy error” beginning in mid-December 2025, when the Fed began buying $40 billion in Treasury bills per month. While the Fed termed this a “technical plumbing operation,” Hunt proves it was a massive liquidity infusion that caused bank loans and leases to explode at double their historic growth rates.
- The 2026 Oil Shock: The blockade of the Strait of Hormuz has created, Hunt calls it, the greatest structural damage to energy markets in modern times. He estimates that oil prices directly and indirectly account for 12% to 15% of the cost of living, meaning the current shock could lift the CPI by as much as 240 to 300 basis points.
- By combining these two events, Hunt argues that the Fed has shifted the aggregate demand curve outward, just as the supply curve has shifted inward. In plain English, this has created inflationary momentum that is likely to push the CPI above 4.5%, or even 5%, in the coming months.
- Because these shocks are global, Lacy is seeing a rapid decline in world trade volume, proceeding even faster than in previous oil shocks, which acts as a “high multiplier” for economic contraction.
The Direction of Interest Rates: A Historic Reversal
- For the first time in over 20 years, Lacy has reversed his long-standing call for lower interest rates. His new outlook for the bond market is decidedly bearish.
- Upward Trend in Yields: He said, in the current environment, long-term Treasury yields will trend upward.
- Short-duration exposure: Reflecting this view, he noted that his firm has reduced its portfolio duration to under one year, seeking safety on the short end of the curve as risks to bond yields remain to the upside.
- To stabilize the market, Hunt believes the new Fed chairman must reverse the entire $300 billion increase in the Treasury bill portfolio as quickly as possible.
Recession risk:
- Lacy warned that “unwinding” this liquidity error, while high oil prices are destroying demand, makes a deep recession nearly unavoidable. (SB: bold emphasis mine)
- On timing: He expects it will take five to nine months for the full weight of these shocks to pull the economy into a formal downturn.
- Target: October 2026 to February 2027
Summary:
- Lacy concluded that the Federal Reserve’s decision to pump liquidity into the system just before the 2026 energy crisis has created a “stagflationary” trap that can only be solved by aggressive Fed balance sheet reduction.
- For investors, this transition means bracing for higher plateaued inflation and rising long-term yields as the economy moves toward a difficult, policy-driven recession.
- Lacy believes the direction of interest rates following a recession will depend heavily on whether the Federal Reserve successfully “normalizes” its balance sheet.
Here is the sequence of events he expects:
- In the near term, he expects the trend in long-term Treasury yields to remain upward due to inflationary momentum from the oil shock and prior monetary policy errors.
- He notes that “reversing the quantitative easing” (the liquidity infusion from late 2025) will eventually lead to reverse effects on asset prices (down) and credit spreads (higher and wider).
- Longer-term: He warned that the path to lower inflation and lower rates usually comes at a high cost. He pointed out that bringing the inflation rate down typically requires destroying demand, much like high oil prices do.
Lacy’s Post-Recession Outlook:
- While he is currently positioned in short-term Treasuries because he expects yields to rise, he suggests that a recession will eventually burn out inflation.
- However, he emphasized that if the Fed tries to cushion the economic pain of that recession too early, as Arthur Burns did in 1974, it risks perpetuating inflation and causing an even deeper downturn later.
In conclusion, Lacy expects rates to trend higher until the Fed aggressively drains liquidity, which will likely trigger a recession that eventually, but painfully, brings inflation and yields back down.
