Global Monetary Policy Shift: U.S. Reflation, Yen Appreciation, and Carry Trade

The September PCE data released by the US Department of Commerce on December 5, 2025, became a key turning point: US core PCE year-on-year was 2.8%, slightly lower than the previous value but still significantly higher than the Federal Reserve’s 2% target. Meanwhile, Japan’s 10-year government bond yield rose to its highest level since 2007 (surpassing 1.5% in December and continuing to approach 2%), and the US 10-year Treasury yield soared by 60 basis points in a single day, resulting in a rare synchronized sell-off across global bond markets. The market generally attributed this to the “Yen Carry Trade reversal,” but Steve Hanke, Professor of Applied Economics at Johns Hopkins University and a leading monetarist, offered a completely different explanation: The real risk is not in Japan, but in the US itself—an impending “reflation” and “overly loose” policy.

I. US Money Supply Has Quietly Surpassed the “Golden Growth Rate”; Reflation Signals Are Severely Underestimated

Hanke has long used the “Golden Growth Rate” rule: If the annual growth rate of M2 remains stable at 6%, then with the US’s 2% potential real growth + 2% money demand growth, a stable 2% inflation can be achieved. Below 6% signals deflation risk; above 6% signals inflation risk.

Latest data (end of November 2025) shows:

• US M2 year-on-year growth has rebounded to 4.5% (Federal Reserve official website), seemingly still in the safe zone;
• However, the portion of M2 created by commercial banks (credit-driven broad money, about 80% of total M2) has reached 6.8%~7.1% (Hanke team estimates), significantly above the 6% warning line;
• In April 2024, the Fed completely removed the “Supplementary Leverage Ratio” (SLR) capital constraint on banks, and starting from Q2 2026, commercial banks are expected to unleash an additional $2.3~2.8 trillion in lending capacity;
• From December 2025, the Fed has officially ended QT (quantitative tightening), no longer shrinking its balance sheet monthly, instead turning neutral or even slightly expanding;
• In fiscal year 2025, the federal deficit/GDP remains at 6.2~6.5%, with about 45% of the deficit financed through issuance of Treasury bills with maturities under one year. These short-term Treasuries are being massively absorbed by Money Market Funds, directly pushing up M2.

Hanke publicly admitted for the first time: “I’ve been saying for the past two years that ‘inflation won’t return unless M2 breaks 6% again.’ Now I’ve changed my tune—bank-created money has surpassed that level, and overall M2 is accelerating. We’re at an inflection point.”

He roughly calculates: If M2 year-on-year reaches 10% in 2026 (which Hanke sees as highly likely), after deducting 2% real growth + 2% money demand growth, the remaining 6% would conservatively correspond to 5% CPI inflation; if not conservative, it could return to 6~7%. This matches the 2021–2022 experience, where the M2 peak of 26.7% corresponded to 9.1% inflation (26.7% ÷ 2.7 ≈ 9.9%).

More importantly, since 2025, the lead-lag relationship between M2 and CPI has shortened dramatically from the typical 12–24 months to just 6–9 months, or even “synchronized,” meaning that once money accelerates, inflation could appear very rapidly.

II. The Fed Remains “Blind,” Tilting Toward Easing Under Political Pressure

Hanke sharply criticized: The Fed claims to be “data dependent,” but ignores the most crucial variable for inflation—the money supply, M. They focus on PCE, CPI, unemployment, and manufacturing PMI, yet ignore the core monetarist formula MV=PY.

At the December 10–11, 2025 FOMC meeting, the market priced in a 94% probability of a 25bp rate cut, a foregone conclusion. The median rate cut expectation for 2026 is 75–100bp. If Trump’s nominee Kevin Hassett actually replaces Powell as Fed Chair in Q2 2026 (prediction markets have raised the probability from 30% in November to 60%), the market will view him as “Trump’s man,” favoring aggressive rate cuts and a weak dollar policy.

This would create a “quadruple easing resonance” together with a boom in bank lending, QT suspension, and deficit monetization. Hanke calls this “the perfect recipe for reflation.”

III. The Truth About the Yen Carry Trade: Not the Main Driver of the Current Bond Selloff, But Could Be the Trigger for a 2026 US Stock Bubble Burst

Prevailing market narrative: Japan’s 10-year JGB yield rises to an 18-year high → yen appreciates → carry trades are unwound → global risk assets are sold off.

Hanke believes this logic is greatly exaggerated:

1. The recent surge in the US 10-year Treasury yield from 3.8% to over 4.6%~4.8% by December was driven mainly not by Japan, but by US reflation expectations and “easing fears” due to Hassett’s potential appointment. Japan’s 10-year JGB yield, though at the highest since 2007, is only 1.5~1.8% in absolute terms—still far below the US, with a spread of over 300bp;
2. The yen is still trading in the 152–155 range, far from the extreme weakness (near 160) seen in August 2024, and carry trades have not yet been systematically unwound;
3. What truly worries Hanke is a “reverse scenario”: If in 2026 the Fed is forced to pause or even resume rate hikes due to reflation, US rates rise again, while Japan stops hiking due to controlled inflation, the yen could rapidly appreciate by 10–15% (back to 130–135). Only then would carry trades face a true “stampede” unwinding.

Hanke and Tim Lee (author of “The Rise of Carry”) have long shown that Japan’s private sector savings rate is persistently high at 8–10% of GDP; while the public deficit is large, the overall current account remains in 4–5% surplus, making Japan the world’s largest, most persistent capital exporter. As long as the yen doesn’t appreciate sharply, carry trades will continue to “pump blood” into US asset bubbles.

If, however, yen appreciation triggers a carry trade reversal, a massive outflow of Japanese capital from US stocks, Treasuries, Mexican peso, and other high-yield assets will return to Japan. This would be a repeat of the August 2024 “yen flash surge” when global stock markets plunged 8–12%, only in 2026 US stock valuations will be even higher (the S&P 500 forward P/E is already at 24.5, with Hanke’s bubble model showing 90th percentile bubble level), making the damage even greater.

IV. Most Likely Macro Scenario for 2026–2027—Hanke’s Latest Judgment

1. First half of 2026: Fed continues rate cuts + SLR removal + deficit monetization → M2 accelerates to 8–11% → inflation rises again to 4–6% → long-end Treasury yields rise instead of fall (reflation trade);
2. Second half of 2026 to 2027: Fed forced to pause rate cuts or even resume hikes → US-Japan rate spread widens again → yen rapidly appreciates 10–20% → carry trade reversal on a large scale → US stock bubble bursts, S&P 500 may correct 25–40%;
3. Global impact: Emerging market currencies (Mexican peso, Turkish lira, Indian rupee) plunge in sync, commodities first surge then crash, gold first suppressed then soars.

V. Investment Recommendations—Selected Quotes from Hanke

1. Don’t try to predict when the bubble will burst, but do acknowledge that we are in a bubble;
2. Immediately rebalance your portfolio to pre-pandemic stock/bond ratios (e.g., from 85/15 back to 60/40 or 50/50);
3. Shorten bond duration, avoid long-dated Treasuries, increase allocation to 1–3 year Treasuries or floating rate notes;
4. Hold a certain proportion of gold and commodities as a dual hedge against monetary overexpansion and carry trade reversal;
5. Watch the yen exchange rate: 145 is the medium-term warning line, below 135 signals the onset of systemic risk.

Conclusion

December 2025 is not the “starting point of a yen carry trade explosion,” but rather the turning point where US monetary policy shifts from tightening to excessive easing. The real risk lies in 2026–2027: The US first experiences reflation, then is forced to slam on the brakes; Japan hikes first, then stops as inflation is controlled; the yen eventually appreciates sharply, carry trades reverse, and the US stock bubble bursts. This is a classic, albeit belated, case study in monetarism—when central banks stop focusing on money supply and only look at employment and near-term prices, inflation and asset bubbles will eventually spiral out of control.

Professor Hanke’s final quote is worth remembering for all investors: “The Fed can ignore the money supply, but the money supply will not ignore the Fed. History will repeat itself, just in a different way—this time, perhaps as a combination of ‘loose then tight policy + yen appreciation.’”