Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Measure Inflation Expectations From Markets
Transcript
- Lucas: If you want to know whether a central bank is winning its fight against inflation, the most honest answer doesn't come from a press conference or a staff projection. It comes from the bond market. Luna: Specifically from the gap between nominal Treasury yields and yields on Treasury Inflation-Protected Securities — TIPS. Lucas: Exactly. That gap is called the breakeven inflation rate. And the version central bankers obsess over is the five-year, five-year forward breakeven rate — basically the market's expectation for average inflation over the five-year period that starts five years from now. Luna: So it's a forward-looking measure that strips out the noise of today's supply shocks and focuses on the medium-term path. Lucas: Right. And that's crucial because a central bank's credibility is judged by whether the public believes it will keep inflation around target over the medium run — not whether it can engineer a single month of low CPI. Luna: This is exactly the kind of thing that makes a complex topic click. And it's why we keep these episodes free and ad-free — no sponsors, no interruptions. If you've ever found yourself explaining a concept from this show to a colleague or friend, that's the best signal we can get. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. Lucas: And we appreciate every single one of those coffees. Now, back to the mechanics — let's break down what the breakeven rate actually captures. Luna: Please, because I think a lot of people assume it's a pure expectation. But it's not. Lucas: It's not. The breakeven rate equals expected inflation plus an inflation risk premium. Investors demand a premium for bearing the risk that inflation comes in higher than expected — that eats into real returns on nominal bonds. So if the breakeven rate is, say, 2.5 percent, maybe expected inflation is 2.2 percent and the risk premium is 0.3 percent. Luna: So the breakeven overstates expected inflation by the size of that risk premium. And the risk premium itself varies over time. Lucas: It does. During the global financial crisis, the risk premium spiked because investors were terrified of deflation, not inflation. During the pandemic reopening, it swung wildly. Central banks have models to strip out the risk premium component, but those models are imperfect. So the raw breakeven is still the most watched version. Luna: Why the five-year, five-year forward in particular? Why not the ten-year breakeven or the one-year? Lucas: Great question. The one-year breakeven is dominated by current oil prices and transitory effects. The ten-year breakeven includes the near term too. The five-year, five-year forward looks at a period that starts five years out — far enough to be beyond the business cycle, but close enough that monetary policy should have full effect. It's the cleanest read on the central bank's credibility. Luna: So if the five-year, five-year forward is well anchored near the central bank's target — say, 2 percent in the US — markets trust that the Fed will get inflation back to target over the medium term. Lucas: Correct. And if it drifts persistently above target, that's a red flag. It means markets are pricing in a regime shift — that the central bank has lost some credibility and investors expect inflation to settle at a higher average. Luna: I remember in mid-2022, that forward rate got up to around 2.6, 2.7 percent. People were worried the Fed's 2 percent target was no longer credible. Lucas: That was a scary moment. The Fed had to raise rates aggressively to re-anchor expectations. And it worked — by late 2023, the five-year, five-year forward was back near 2.3 percent, and it's hovered around 2.2 to 2.4 percent since. Not perfectly at 2, but close enough that the risk premium explains the gap. Luna: Let's talk about the risk premium a bit more. What drives it? Lucas: A few things. First, uncertainty about the central bank's reaction function — if the Fed seems dovish on inflation, the risk premium rises because investors fear they won't act in time. Second, fiscal policy — larger deficits can increase the inflation risk premium because investors worry about monetary financing. Third, the level and volatility of actual inflation itself. Luna: So it's not just a technical wedge. It's actually informative. A rising risk premium can signal that markets are losing faith even if expected inflation holds steady. Lucas: Exactly. That's why central banks look at both the breakeven and survey-based expectations. Surveys don't have a risk premium, but they're slow-moving and can be stale. Market prices adjust in real time. Luna: And they're based on real money. People putting their own capital at risk. Lucas: Right. So the breakeven rate is a revealed preference. But there's a caveat: TIPS markets are relatively small. The entire stock of outstanding US TIPS is about $1.8 trillion, compared to over $20 trillion in nominal Treasuries. So liquidity premiums can distort the breakeven. Luna: Meaning during times of stress, if everyone piles out of TIPS, the price drops, yields rise, and the breakeven narrows — even if inflation expectations haven't changed. Lucas: Precisely. That's what happened in March 2020. The breakeven rate collapsed, but it was mostly a liquidity flight, not a sudden belief in deflation. The Fed had to step in to stabilise the TIPS market. Luna: So how do central banks separate signal from noise? Do they just look at the breakeven raw, or do they have adjusted measures? Lucas: Most central banks publish their own estimates of inflation expectations that adjust for risk premiums and liquidity. The Fed has a model called the ACM — Adrian, Crump, and Moench — that decomposes nominal yields into real yields, expected inflation, and risk premiums. The Bank of England publishes a similar measure using its own yield curve model. Luna: But those model outputs are only as good as the assumptions. And they don't always move in lockstep with the raw breakeven. Lucas: That's right. Which is why policymakers often cite both. When Jerome Powell gives a press conference, he might reference the five-year, five-year forward breakeven, but he'll also mention the survey of professional forecasters or the Michigan survey. He's triangulating. Luna: Let's talk about the other side of the Atlantic. The European Central Bank relies heavily on the same measure, but they face an extra challenge: the euro area has a less developed market for inflation-indexed bonds. Lucas: True. The euro area inflation swap market is actually more liquid than the bond market for some maturities. So the ECB often looks at the five-year, five-year forward inflation swap rate rather than the bond breakeven. It's the same concept, but based on derivatives. Luna: And do those swaps have a risk premium too? Lucas: They do, but it's different. The swap market embeds a credit risk component — the counterparty risk of the bank you're trading with. During the eurozone debt crisis, that was a big distortion. But post-crisis regulation has made it cleaner. Luna: So the five-year, five-year forward is essentially the universal benchmark for central bank credibility across developed economies. Lucas: I'd say it's the most important single market-based measure. Not the only one, but the one that gets the most attention in policy meetings. When that number moves, it moves markets — and it moves central bankers. Luna: I want to talk about a specific recent episode. In early 2026, there was a lot of debate about whether the five-year, five-year forward was drifting too high. What was happening? Lucas: Good memory. Around February 2026, the five-year, five-year forward breakeven in the US pushed above 2.5 percent — the highest since mid-2023. Some commentators said it showed the Fed had lost control. But when you looked at the components, a big chunk was the risk premium rising due to fiscal uncertainty — the debt ceiling debate and proposed tariff increases. Luna: So the raw breakeven was signalling potential de-anchoring, but the model-based expected inflation component was still around 2.2 percent. The Fed chose to look through it. Lucas: Exactly. And in subsequent months, as fiscal clarity improved, the breakeven came back down. That's a textbook case of why you can't just trade on the raw number. You have to understand what's driving it. Luna: What about the Bank of Japan? They've been fighting deflation for decades. Do they use this measure? Lucas: They do now, but it's tricky. Japan has very little issuance of inflation-indexed bonds, so the breakeven market is thin. The BOJ instead relies heavily on survey data and their own forecast. But since they adopted the 2 percent target, they've been trying to develop the market. The five-year, five-year forward swap rate has become more referenced in recent years. Luna: So the measure is only as useful as the market behind it. Lucas: Exactly. In a deep, liquid market like US Treasuries, the signal is rich. In a thin market, it's more noise. That's why emerging market central banks rarely use breakevens — their local currency bond markets aren't deep enough, and inflation-indexed issuance is minimal. Luna: So they rely on surveys and dollarisation proxies — like how much people are converting to dollars as a hedge. Lucas: Right. Or the spread between local currency and dollar-denominated bonds. But those are even noisier. Luna: Let's bring it back to the listener. If someone wants to follow the five-year, five-year forward breakeven, where can they find it? Lucas: The Federal Reserve Bank of St. Louis publishes it on FRED. The ticker is T5YIFR — T-5-y i f r. That's the raw breakeven. The New York Fed publishes the ACM model decomposition. And Bloomberg terminals have it as a standard screen. For the euro area, you can find the five-year, five-year inflation swap rate on Bloomberg or the ECB's website. Luna: So it's accessible. And watching it over time gives you a real-time window into how markets view central bank credibility. Lucas: And that's the key insight. The five-year, five-year forward breakeven isn't a perfect inflation forecast. But it's the closest thing we have to a daily lie-detector test for monetary policy. When it stays anchored, the central bank is winning. When it breaks loose, you know trouble is coming before any CPI report confirms it. Luna: And that's why every central banker — from the Fed to the ECB to the Bank of England — watches it like a hawk. Lucas: They do. Because in the end, inflation is always and everywhere a monetary phenomenon — but it's also always and everywhere an expectations phenomenon. Get expectations right, and the rest follows.