Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Reads Surging Inflation Expectations
Transcript
- Lucas: The May CPI print hit 4.2 percent annual — highest in three years. That's the headline everyone saw. But the number the Fed is watching more closely right now is a different one: the 10-year breakeven inflation rate, which ticked up to 2.32 percent on June 15. Luna: And breakeven inflation — that's just the difference between nominal Treasury yields and TIPS yields, right? The market's expectation for average inflation over the next decade. Lucas: Exactly. And that number has been creeping higher even though core inflation, ex food and energy, actually moderated a bit in May. The core CPI month-over-month was softer than expected, but the breakeven went up. That divergence is what makes the Fed uneasy. Luna: So the market is pricing in higher long-run inflation even as the monthly data shows some cooling? That seems contradictory. Lucas: It is — unless you think the market is looking past the current data and worrying about something structural. The breakeven rate moved from about 2.15 in early May to 2.32 now. That's 17 basis points in six weeks. For a ten-year expectation, that's a meaningful shift. Luna: And the Fed's own projections show the median FOMC member expecting inflation to settle around 2.2 percent over the longer run. So the market is now pricing in expectations above the Fed's own forecast. Lucas: That's the worry. When market-based inflation expectations rise above the Fed's target, it suggests the central bank is losing credibility on its commitment to price stability. And once expectations become unanchored, they're hard to reel back in. Luna: But how much weight does the Fed actually put on breakevens versus survey-based expectations? The University of Michigan survey, for instance, shows one-year expectations at 5.1 percent — that's elevated but it's very short-term. Lucas: They watch both. The Michigan survey's one-year number is noisy — it reflects actual pain at the grocery store. But the five-year Michigan expectation, which is a better gauge of long-run anchoring, has stayed around 3.1 percent. That's still above the Fed's target but hasn't spiked the way the one-year has. Luna: So the breakeven moving above 2.3 might be more concerning to the Fed than the Michigan survey, because it's market participants putting real money behind their expectations. Lucas: Right. The breakeven is a traded price. It's not a poll. And it's been drifting higher even as the Fed holds rates at 3.62 percent effective. The fed funds rate is already restrictive, but if expectations continue to rise, the Fed may feel it needs to hold steady longer or even hike again. Luna: Though the ECB just hiked for the first time since 2023 — that's a different context. Europe has the energy shock from the Iran conflict pushing wholesale prices. The US has a different mix. Lucas: True. The US wholesale price index jumped 1.1 percent in May, mostly on energy. But the core PCE, which the Fed targets, is still running around 2.8 percent annualized. That's above target but not accelerating. The puzzle is why breakevens are rising when core PCE is flat. Luna: Maybe it's the uncertainty around tariffs and geopolitical risk. The market might be pricing in a risk premium — a chance that supply shocks keep inflation higher for longer, even if the Fed doesn't tighten further. Lucas: That's probably part of it. There's also the fiscal side: the deficit is still large, and the market might be questioning whether the Fed can remain independent if political pressure mounts to keep rates low. That's a longer-term concern baked into the ten-year breakeven. Luna: So if the Fed sees breakevens rising, what can they actually do? They can't control the ten-year real yield directly. They can only set the short-term rate. Lucas: They can communicate. They can push back in speeches and in the dot plot. And if they need to, they can hike. But right now, the market is pricing roughly a 40 percent chance of a hike at the July FOMC meeting. That's up from 20 percent a month ago. Luna: And a hike would be a strong signal that the Fed is serious about keeping expectations anchored, even if the real economy is slowing. Lucas: Exactly. The risk of doing nothing is that expectations become self-fulfilling. If businesses and households expect 3 percent inflation, they'll set prices and wages accordingly. The Fed knows that history well — the Volcker era was all about breaking that psychology. Luna: But Volcker had to push rates to 20 percent. We're at 3.62. So we're nowhere near that level of pain. But the psychology question is the same. Lucas: Same mechanism, different magnitude. And that's why the Fed is so focused on this breakeven move. It's a canary in the coal mine for whether the disinflation story is still intact. Luna: And the canary is chirping a little louder than the Fed would like. Lucas: It is. And speaking of keeping things going — I'll be honest, the reason we can spend time digging into breakeven rates and survey data without running ads or sponsored segments is that a small group of listeners chips in monthly through buy me a coffee dot com slash fexingo. Luna: And it genuinely makes a difference. It's what allows us to do deep dives like this instead of having to chase clicky headlines. If you've gotten something out of the show, that's the best way to keep it ad-free. Lucas: So anyway, back to the breakeven story. The other data point that ties into this is the Treasury yield curve. The two-year note is at 3.63 percent — essentially flat with the fed funds rate. But the ten-year is at 4.42, which is down 12 basis points over the last week. Luna: So the curve is steepening, but from the long end coming down. That's not typical. Usually a steepening curve signals stronger growth expectations. Here it seems like the long end is falling because of safe-haven demand, maybe on geopolitical concerns. Lucas: That's exactly what's happening. The ten-year yield dropped despite the breakeven rising. That means real yields — the ten-year TIPS yield — fell even more. So the market is pricing in lower real growth but higher inflation compensation. That's a stagflationary mix. Luna: And that's the worst case for the Fed. Because if growth slows but inflation stays sticky, they can't cut rates to stimulate. They're stuck. Lucas: Stuck between a rock and a hard place. And that's the scenario the Fed has been trying to avoid since 2022. The fact that breakevens are rising while real yields fall suggests the market sees that risk as more probable now. Luna: Let's talk about what the Fed can actually do at the next meeting. The June meeting is this week — June 16 and 17. So we're literally recording the day before the decision. Lucas: Right. The decision is tomorrow. And the market expects no change. The fed funds rate is at 3.62, and the effective rate has been flat. But the statement and the dot plot will be scrutinized for any shift in tone about inflation expectations. Luna: Do you think they'll mention breakevens explicitly? They usually talk about 'market-based measures of inflation compensation'. Lucas: They'll probably say something like 'inflation expectations remain well anchored' — that's their standard language. But if they drop the word 'well' or add a caveat, that would be a signal. I'll be watching for any change in the characterization. Luna: And the dot plot. The March dot showed two cuts in 2026. If that changes to one cut or zero, that's a hawkish signal. Lucas: Exactly. And given the breakeven move, I wouldn't be surprised if the median dot shifts to one cut or even no cuts. The Fed wants to keep optionality, but they also want to signal that they're not going to ease prematurely. Luna: Especially with the UK economy shrinking 0.1 percent in April and the ECB hiking — the global backdrop is messy. The Fed might want to appear more resolute. Lucas: Right. The UK contraction is partly due to the Iran conflict weighing on trade. The ECB hiked to contain energy-driven inflation. The US has been relatively insulated, but global spillovers matter. The Fed can't ignore that the rest of the world is tightening. Luna: So the bottom line: the Fed is watching inflation expectations more than the monthly CPI print. The breakeven rate is the key metric. And if it stays above 2.3, the Fed is likely to hold rates higher for longer. Lucas: That's the takeaway. The headline number matters, but the psychology of inflation is what will determine the path of rates. And right now, the market is telling us that psychology is shifting. Luna: We'll see what the Fed says tomorrow. Lucas: We will. And we'll cover it in the next episode.