By Michael Every of Rabobank
The US CPI print for January was red hot at 0.5% m-o-m headline and 0.4% core, with the former rising to 3.0% y-o-y and the latter to 3.3%. Even if due to things like eggs it leaves egg on the face of the “Rate cuts!” crowd forced to crowd the next Fed into end- 2025. Worse, as yields jumped and Fed Chair Powell huffed and puffed in Congress, President Trump demanded lower US rates and said they would sit alongside higher US tariffs, making clear economic statecraft is in and economic policy is out.
However, that was far less important than the ice-cold realpolitik served up next. US Defence Secretary Hegseth announced the US, while backing NATO, was pivoting to Asia and Europe must defend itself better by spending 5% of GDP on it, not 2%. That’s been rumored for a while and most of Europe has treated it as a joke, not a reality. Nobody is laughing now.
Not when Hegseth added Ukraine won’t enter NATO or recover its lost territory, and no US troops will be in the no-man’s land guarding it from Russia, only Europeans, who will not be covered by NATO’s Article 5 mutual defence pact. Moreover, Europe will pay most to rearm and rebuild Ukraine, while the US gets access to its rare earth and mineral rights for any aid provided to Kyiv. Some still might have seen this all as a joke.
Until President Trump started ceasefire talks with President Putin, with no European representation, suggesting a possible rapprochement: @vtchakarova asks what if Trump agrees to join China’s Xi and attend May’s 80th anniversary of its WW2 victory in Red Square?
Europe’s response via the “Weimar+” group was: “We are ready to enhance our support for Ukraine. We are committed to its independence, sovereignty and territorial integrity in the face of Russia’s war of aggression. We share the goal to keep supporting Ukraine until a just, comprehensive, and lasting peace is reached. A peace that guarantees the interest of Ukraine and our own. We are looking forward to discussing the way ahead together with our American allies. Our shared objectives should be to put Ukraine in a position of strength. Ukraine and Europe must be part of any negotiations. Ukraine should be provided with strong security guarantees. A just and lasting peace in Ukraine is a necessary condition for a strong transatlantic security. We recall that the security of the European continent is our common responsibility. We are therefore working together to strengthen our collective defence capabilities.”
However, let’s be equally clear: this group’s unfortunate title is historically confrontational; its pledges are *highly* aspirational, as Europe has not been invited to attend peace talks, cannot force admittance, and is talking about pushing Russia out of occupied territories without US help; and it must be transformational if the stated goals are going to be achieved.
We are talking Covid-era fiscal deficits for decades if Europe (already flirting with an energy price cap) and the UK (close to selling off two naval vessels to Brazil and returning the key Chagos islands to Mauritius) stop LARPing and truly rearm and rebuild Ukraine. That also means guns-not-butter choices given Russia is spending $462bn on defence on a PPP basis, more than Europe combined, and its war political economy won’t shift back to “because markets” and “Rate cuts!” when it just delivered this victory. Such wishful thinking is almost entirely European.
If Europe opts not to rearm nor arm Ukraine and tries to talk markets, rate cuts, and butter, Moscow will happily agree – but it will want a weaker, divided, energy-dependent, Finlandized Europe. Which some critics would allege is already mirrored from the US side.
For Europe, the ice-cold realpolitik logic is that for many years it likely plays second fiddle to the US tune; or Russia’s; or both; or it has to change its political-economy music entirely. But talk is cheap, and war and preventing war isn’t; and freedom isn’t free, and neither is it free trade or free money, even if there are potential upsides here, for example see our recent paper on the positive long-run productivity benefits of higher military R&D spending, which Europe could do with. Markets are not yet grasping the scale of these shocks, which is perhaps understandable. But when they do, they will move.
Similarly, in Canada, Liberal Party leadership candidate Carney has pledged to use the government’s emergency powers to “accelerate the projects that we need.” Like spending 5% of GDP on defence?
Meanwhile, in the Middle East, far closer to the EU than the US, Israel is reportedly considering strikes on Iran’s nuclear sites later in the year, news that comes days ahead of a deadline that may see it restart its war with Hamas.
And Asia has to start thinking about the consequences of the US pivoting in that direction. What does that mean for US ally defence spending? Does Japan have to think about a 5% of GDP figure in short order too? What about Australia and New Zealand? Has Hegseth learned the names of any ASEAN members yet? The fiscal, rates, FX, and real economy implications are again enormous – and that’s before we get to the geopolitical tensions inherent in this strategy, which should be clear. The Trump – Modi meeting we are about to see is also of great importance in this and other regards.
Do recall that we had months ago dubbed 2025 as ‘The Year of Living Dangerously’!
On which note, today we may also get US reciprocal tariffs announced. On that, Yannis Varoufakis talks of ‘Donald Trump’s economic masterplan: He is plotting an anti-Nixon shock’, which doesn’t refer to his latest pivot to Moscow to try to isolate Beijing, but underlines a hypothesis I’ve been floating for some time: the US wants to retain global dollar hegemony while NOT running a large structural trade deficit.
There may be some odd cause-and-effect thinking on rates and FX ordering in his article, but that central point is key, and again has tectonic significance for markets – who again don’t yet see it for the most part. Indeed, most economists will tell you this cannot be done when economic history, and Yannis, show mercantilism can get you there quite easily – just not in a way that markets or trading partners will like.
Put all this together and red-hot US CPI is playing second fiddle: it’s ice-cold realpolitik which is the real story.
