Tomorrow's inflation: The market's verdict

Tomorrow's inflation: The market's verdict

In today's financial markets, all eyes are on the Federal Reserve, and the pace of its decisions about its target interest rates.


The Federal Reserve (Fed), in turn, discusses its decisions, both in public and in private, in terms of its twin mandates – supporting employment and managing inflation.  In both cases, it's critical for the Fed to have views about where both are going. Thankfully, there's lots of good data available on which to base forecasts for employment – including demographic trends, which tend to change slowly.

Inflation is another matter entirely. The majority of forecasts depend on economic models developed using differing methods, and wildly different ways of measuring inflation.

But thanks to financial markets, there is one way of directly measuring inflation expectations, two, five and even ten years into the future. That measure is known as the "breakeven rate", which in the U.S. is available in 2-year, 5-year, and 10-year flavors. The rates compare the yields of 2-, 5- and 10-year Treasury securities to the yields of U.S. inflation-linked Treasury securities ("TIPS") of each maturity. The idea is that the difference between the inflation-linked and non-linked Treasuries reflects these markets' expectations about inflation 2, 5 and 10 years out.

Like all market-based measures, these breakeven rates change daily, based on expectations. Which means that today's breakeven rates are far from reliable as actual predictors of future inflation rates.  But the figures are very useful as a way of capturing today's expectations about the future.

For now, what does the 5-year 5-year breakeven say about inflation? 

 

Far from constant: One market’s changing verdict on inflation

Breakeven inflation and the Fed's target rate (%)

Source: Bloomberg, as of August 23, 2017.  Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

One observation: assuming what we know today, today’s inflation expectations bear little resemblance to yesterday’s, or to the Fed's target long-term inflation goal of 2 percent.  Note that these expectations have wavered over the past two years, as faith in the Fed, changes in commodity prices (including oil) and improving employment have waxed and waned.

Second, it's worth considering that the Fed constantly reviews its economic assumptions – including its expectations for interest rates over the next two years.  And in recent weeks, there's been talk that the 2 percent bogey may be too low, given the economy’s still-growing employment figures.

And perhaps most important, expectations about the future reflect changing beliefs about government policies, which have been fluctuating rapidly under the new theoretically undivided government in Congress and its current faceoff with the Executive Branch.  So while the future looks clear in the sense that there’s a measurable, numeric expectation embedded by today’s prices, that expectation is anything but stable. That’s why it's important to look both ways before crossing off any investment choices – low inflation is far from a given over the next few years.

 

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U.S. Treasury Inflation Protected Securities (“TIPS”) are bonds that receive a fixed, stated rate of return, but they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk.

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Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.