Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the 10-Year Breakeven Inflation Rate
Transcript
- Lucas: So the Fed has a lot of inflation measures they watch — CPI, core PCE, trimmed mean, median CPI, you name it. But there's one market-based number that I think gets underappreciated: the ten-year breakeven inflation rate. Luna: That's the difference between nominal Treasury yields and TIPS yields, right? Essentially what the bond market expects inflation to average over the next decade. Lucas: Exactly. And as of this week, that number is 2.24 percent. That's up just a tick from 2.23 last week, but it's been hovering in that tight range for a while. Now, what's interesting is that the actual CPI print for May came in at 334.0, up from 332.41. That's about a 2.4 percent annualized rate — so the market expectation is slightly below what we're actually seeing in the official numbers. Luna: But the Fed's target is based on core PCE, not headline CPI. And core PCE has been running around 2.7 percent year-over-year, if I'm reading the May data right. Lucas: Right. Core PCE is at 130.1, up from 129.67 in April. That's still a bit above the 2 percent target. So the breakeven rate of 2.24 is telling us the market thinks inflation will average above the Fed's target over the next decade, but not by a huge margin. It's a far cry from the 2.5-plus we saw in late 2023. Luna: So if breakevens are well-anchored around 2.2, does that give the Fed cover to hold rates steady even if CPI stays a bit elevated? Lucas: That's the argument. The Fed has been saying they need to see sustained evidence that inflation is moving toward 2 percent. The breakeven rate is one signal that long-run expectations are anchored. If that number starts creeping toward 2.5, that would be a red flag. But right now at 2.24, it's in a zone that historically hasn't spooked policymakers. Luna: But there's a twist — the five-year breakeven is higher than the ten-year. That usually signals that the market expects inflation to moderate over time. So near-term pressures, longer-term stability. Lucas: That's a great point. The five-year breakeven is around 2.4, I believe, versus the ten-year at 2.24. So the curve of inflation expectations is downward sloping. That actually aligns with the Fed's narrative that the current inflation is sticky but not structural. The market essentially agrees — high for a few years, then settling down. Luna: And doesn't that tie into the inverted yield curve we keep talking about? The ten-year nominal yield at 4.57 percent, the two-year at 3.69 — that inversion is partly driven by the same expectation that inflation will fall. Lucas: Exactly. If investors expected inflation to stay high, they'd demand higher nominal yields on longer-term bonds. The fact that the ten-year yield is below the two-year suggests the market expects the Fed to cut rates as inflation cools. And the breakeven rate is the inflation component of that equation. Luna: So when the Fed looks at the breakeven, they're not just looking at a number — they're looking at the market's vote of confidence in their policy. Lucas: Precisely. And that's why I think this metric is underappreciated. CPI and PCE are backward-looking. The breakeven is forward-looking. It's not perfect — it's influenced by liquidity premiums and technical factors in the TIPS market — but it's one of the few real-time reads on inflation expectations we have. Luna: And right now, it's telling us the market trusts the Fed enough to keep long-term expectations anchored, even if the monthly data is bumpy. Lucas: That's the key takeaway. The Fed's biggest fear is that inflation expectations become unmoored. The breakeven rate is their canary in the coal mine. At 2.24, the canary is chirping, not choking. Luna: I'm going to steal that line for my next meeting. Lucas: You know, when we talk about the Fed's tools, it's easy to focus on the federal funds rate. But the breakeven rate is one of those behind the scenes indicators that really shapes the conversation. If you've found these insights useful, it's worth noting that keeping this show ad-free and independent relies on listeners who value that kind of depth. Luna: Absolutely. And if you want to support the work, there's a simple way — head to buy me a coffee dot com slash fexingo. No pressure, just a way to keep the economics conversation going. Lucas: So back to the breakeven — one thing I want to watch is the July CPI report due out next week. If that comes in hot, we could see the five-year breakeven push above 2.5, which would test the Fed's patience. But for now, the ten-year at 2.24 suggests the market is giving them the benefit of the doubt. Luna: And if the breakeven jumps, that might force the Fed to signal a rate hike at the September meeting, even if the labor market is softening. Lucas: That's the tension right now — the Fed is between a rock and a hard place. Inflation is still above target, but the labor market is losing steam. The breakeven rate is one of the few metrics that helps them weigh those two forces. So keep an eye on it. Luna: Will do. And we'll be watching the July CPI numbers with you. Lucas: Next time, we'll dig into the jobs side — the participation rate is at a 50-year low outside the pandemic, and that's a whole other headache for the Fed. But for now, that's the breakeven story.