Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Breakeven Rate Spread Now
Transcript
- Lucas: So the 10-year breakeven inflation rate ticked up to 2.26 percent this week, from 2.24. That is exactly where the 2-year breakeven is sitting. And that flatness — that's actually the more interesting story than the level itself. Luna: Because normally you'd expect the 2-year to be higher or lower than the 10-year, right? They almost never line up perfectly. Lucas: Exactly. Historically, the spread between the 2-year and 10-year breakeven — so, near-term inflation expectations minus long-term expectations — tends to be positive when the economy is overheating or when oil spikes, and negative when the Fed is tightening hard and the market believes they'll crush inflation quickly. Luna: And right now it's essentially zero. Lucas: Zero. Which tells you the market sees the same inflation risk two years out as ten years out. That is unusual. It suggests investors think the Fed has inflation pinned in a narrow range, but also that they don't see it returning to 2 percent anytime soon either. Luna: Well, the latest CPI print — May's headline at 334.0, core at 336.1 — both still creeping up. So that 2.26 breakeven is basically the market saying 'we believe you'll keep it contained, but we don't believe you'll get it back to 2.' Lucas: That's the credibility problem in a nutshell. The Fed's own projection — the dot plot — has the policy rate staying above 3.5 percent through next year. But the 2-year breakeven has been stuck around 2.25 for months. It's as if the market is pricing in a permanent half-point overshoot above the target. Luna: And the flatness across maturities means investors don't expect that overshoot to resolve differently in the near term versus the long term. There's no re-anchoring story built into the curve. Lucas: Right. If the market expected the Fed to eventually succeed, you'd see the 10-year breakeven below the 2-year — a downward-sloping term structure. That's what we had briefly in late 2023. But now it's flat. And flat is actually more worrying than steep, in a way. Luna: Because steep would at least imply movement — convergence toward target. Lucas: Exactly. Flat says 'this is the new normal.' That's the kind of expectation that can become self-fulfilling. If every business owner and bond trader acts as if 2.25 percent inflation is the floor, then wage contracts get written at 3 percent, rents get reset higher, and the Fed has to validate that expectation or break the economy to dislodge it. Luna: So what does the Fed actually watch for here? Is it the level, the spread, or the direction? Lucas: All three. But the spread is the cleaner signal right now because the level is ambiguous — 2.26 could be a rounding error away from 2 percent if you squint. But a zero spread between the 2-year and 10-year breakeven is a structural statement. It tells you the market's inflation regime has no built-in reversion. Luna: And we've talked about the participation rate falling to 50-year lows — that's a supply-side story. But this breakeven spread is purely a demand-side expectations story. They're related, though, aren't they? Tight labor market keeps wage pressure up, which feeds into near-term inflation expectations. Lucas: They're absolutely connected. With participation so low, the Fed can't rely on labor supply to cool wage growth. So the burden falls entirely on demand destruction via higher rates. And if the market doesn't believe those rates will push inflation back to 2 percent, then the breakeven curve stays flat — or even inverts. Luna: Has the breakeven spread ever stayed this flat for this long before? Lucas: Not really. In the 2000s, the 2-year and 10-year breakevens were almost always a few basis points apart — usually 10 to 30 basis points. The only time they converged this tightly was during the 2008 financial crisis, when everything was frozen, and briefly in 2011 during the debt ceiling standoff. But those were stress events, not a steady state. Luna: So this is a new regime. Lucas: That's what worries a lot of Fed watchers. If the flat breakeven curve persists through the next CPI print, through the next jobs report, through the next FOMC meeting — then the committee has to ask themselves whether their communication is failing, or whether their policy rate is simply not restrictive enough. Luna: Speaking of the next FOMC meeting — we're five weeks out from the July 29th decision. The fed funds rate is at 3.62 on the daily effective, 3.63 on the June average. No one expects a move. But the breakeven spread might influence the tone of the statement. Lucas: Absolutely. Chair Powell could easily say something like 'inflation expectations remain well anchored' — but the flat term structure is a subtle challenge to that claim. 'Well anchored' usually means stable at 2 percent. Stable at 2.25 is anchored, but at the wrong altitude. Luna: And there's a global dimension here too. India's CPI accelerated to 4.38 percent in June. China's producer inflation hit a near-4-year high. We're not an island. Lucas: No, and imported goods are a factor. But the breakeven curve is a domestic market signal — it's built from U.S. Treasury yields and TIPS yields. So it's specifically about how American investors view the Fed's credibility. And right now, the message is: we trust you to keep inflation from spiking, but we don't trust you to get back to 2. Luna: Which is actually a more nuanced signal than just 'inflation is too high.' It's about the path. Lucas: Exactly. And that's why I think the Fed should be watching this spread more than the headline breakeven level. Because the level can fluctuate with oil prices or a bad CPI print. But the spread reveals the market's underlying conviction about the central bank's trajectory. Luna: You know, when we talk through stuff like this — the breakeven spread, the term structure, the credibility question — I realize how much of what we cover is about decoding signals that most people never hear about. And honestly, that's why I love doing this show. Lucas: Same. And it's also why listener support matters so much. We keep this podcast ad-free — no sponsor reads, no interruptive commercials — entirely because of people who chip in at buy me a coffee dot com slash fexingo. It's a small way to ensure we can keep drilling into these arcane but critical details without any outside pressure. Luna: Absolutely. If walking through the economy with us has made something click — whether it's the breakeven spread or the participation rate — that's the exact reason to support. It keeps the podcast independent and focused on what matters. Lucas: So back to that flat spread. If the 2-year and 10-year breakevens remain at parity through the July 29 FOMC meeting, I think we'll see a more hawkish tone in the statement — probably a reference to 'elevated inflation expectations' even if the committee leaves rates unchanged. Luna: Especially with core PCE still running at 130.1, up from 129.67. That's not a screaming hot number, but it's moving in the wrong direction. Lucas: Right. And the PCE deflator is the Fed's preferred measure, not CPI. So if the breakeven curve is telling them the market doesn't believe in the 2 percent target, they'll need to either adjust their communication or eventually adjust their policy. The flat spread is a warning light that's easy to miss if you're only looking at the level. Luna: So what should listeners watch for next? The spread, or the next CPI print? Lucas: Both. But if the spread stays flat through August, that's a bigger deal than any single CPI number. Because a single CPI print can be revised or dismissed as noise. A flat breakeven curve that persists for months is a regime signal. And the Fed ignores regime signals at its peril.