We remain committed to supporting maximum employment, bringing inflation sustainably to our 2 percent goal, and keeping longer-term inflation expectations well anchored. Our success in delivering on these goals matters to all Americans.
— Federal Reserve Chairman Jerome Powell, December 18, 2024 Press Conference
Summary
Comment
The chart below shows the change in 10-year yields over the first 100 days of each Fed rate-cutting cycle since 1963 (no cutting cycles between 1963 and 1967).
The black line shows how rates have responded to the 2024 rate-cutting campaign. Only 1981 (brown) saw a bigger yield rise when the Fed was cutting.
When the Volcker Fed started easing from the 20% funds rate peak in 1980, the bond market rejected the rate cuts and drove 10-year yields higher, to 15.8%, by September 1981.Ed Yardeni famously called them “bond market vigilantes”. Yields went so high by the fall of 1981 that parts of the economy started breaking. These high yields also broke the back of inflation.
Current bond market yields do not have to soar like they did 40 years ago to “break things.” We would argue if the Fed does not back off the rate-cutting talk, bond yields will go as high as needed to start breaking things, including inflation.
Are TIPS Breakevens Signaling Five More Years of Inflation?
5-year/5-year TIPS inflation breakevens show the market’s pricing of the 5-year average of inflation in five years (to eliminate crosscurrents like gasoline prices). The chart below comforts the Fed that inflation is “well-anchored.” Its current level is within its pre-pandemic range.
Other market measures are far less reassuring. We believe they matter at least as much as the chart above.
For instance, the next chart shows the 2-year and 5-year inflation breakeven rates derived from measuring the “nominal” and TIPS (or “real”) yield spread at the 2-year and 5-year maturities. These measures are the expected average inflation rate over the next two years (blue) and five years (orange).
As noted with the vertical line, these measures started pricing in more inflation right after the Fed began cutting rates in September.
Most economists would note gasoline prices heavily influence TIPS breakevens under five years. They are correct.
However, as the next chart shows, the national average of gasoline prices (orange) has been falling while the 2-year inflation breakeven rate (blue) has been rising. This began around the time the Fed started cutting, suggesting the inflation impulse over the next two years is even stronger as falling gasoline prices are not arresting it.
Beyond the move since the Fed hiked in September, the larger TIPS market is signaling inflation problems for the next few years.
The next chart shows the 5-year inflation breakeven rate. It is color-coded, showing the level of expected inflation priced before Covid-19 (red) and after Covid-19 (blue).
The gray line and shaded area show each period’s average and standard deviation.
The post-Covid inflation breakeven rate saw a higher “step function” in both the average and standard deviation.
Post-Covid, the market consistently expects a higher level of inflation over the next five years than it did pre-Covid. It trades like we are in a higher inflation regime.
The next chart uses the same construction as the previous one but for the 10-year inflation breakeven rate. It jumped higher, too, but the change is not as pronounced as was the 5-year maturity’s change.
What do these charts tell us? The market is worried about inflation for the next two to five years, but not five to ten years out.
In other words, there will be an inflation problem until 2029, which the Fed is heightening by cutting rates.
What Is the Public Signaling?
The next chart shows the median forecast for inflation over the next five to ten years, based on a question in the University of Michigan’s Consumer Confidence monthly survey.
Long-term medians may be masking inflation concerns within this survey. This is evident when looking at the mean (average) versus the median survey response.
Below are the median (black) and mean (blue). The bottom panel shows the biggest difference between these two measures over the 45 years of this survey.
In other words, this survey’s measure of inflation expectations is skewed toward higher levels (mean). The interquartile range, shown next, illustrates this.
The top 25% (orange) of respondents expect inflation to average 6% next year, while the bottom 25% (blue) expect inflation to average only 1%. The bottom panel shows the widest difference between the two.
One-quarter of the public believes inflation will average 6% over the next 5 to 10 years (orange), close to the 1970s average of 6.8%. This would be nothing short of a crisis.
But, one-quarter of the public thinks inflation will average 1% (blue). As the next chart shows, 13% of respondents think we will see outright falling prices, or deflation, over the next 5 to 10 years.
These 13% are more likely mistaking falling inflation rates for falling prices. President Biden made the same mistake last year.
Let me be clear to any corporation that hasn’t brought their prices back down even as inflation has come down: It’s time to stop the price gouging.
Give American consumers a break.
— Joe Biden (@JoeBiden) November 30, 2023
Inflation expectations are volatile and churning to a degree not seen in decades. This can be seen in the standard deviation of responses (orange), which measures how wide the range has to be to capture 67% of the respondents. The standard deviation has exploded in the last few years, signaling a strong disagreement about inflation, with the mean saying they are skewed higher.
Or, inflation is unanchored.
Conclusion
Since the Fed started cutting in September, inflation expectations have increased despite gasoline prices falling. This follows the TIPS market pricing more inflation for the next five years.
Despite a stable median, the public shows little evidence that inflation is anchored. One-quarter is worried about a rerun of the 1970s, one-eighth is concerned about a rerun of the Great Depression, and the rest are churning their expectations to a degree not seen in the 45 years of this survey.
Given all this, the Fed must recognize that the market is signaling rate cuts are unnecessary and heightening already elevated inflation expectations.
If the Fed wants yields to go down, maybe they should signal an end to the rate cuts. Until then, headlines like these will only drive yields higher:
Chicago Fed President Austan Goolsbee (Friday, December 20)
- GOOLSBEE: FED RATES TO GO DOWN BY ‘JUDICIOUS AMOUNT’ IN 2025
- GOOLSBEE: FED RATES CAN COME DOWN OVER 12-18 MONTHS
San Francisco Fed President Mary Daly (yesterday, December 23)
- FED: VERY COMFORTABLE WITH PROJECTION OF TWO RATE CUTS IN 2025
NY Fed President John Williams (Friday, December 20)
- WILLIAMS: ‘I DO THINK WE’RE PRETTY RESTRICTIVE’ WITH RATES
- WILLIAMS: DON’T THINK WE’RE AT LONG-RUN NEUTRAL RATE NOW
- WILLIAMS: MODEL ESTIMATE IS 0.75% LONG-RUN REAL NEUTRAL RATE
(Williams argues that the neutral funds rate is 2.75%, with a 2% inflation target plus a 0.75% real rate. So the Fed has a lot of cutting to do in 2025)