Jan 5, 2023 - Economy

The bond market's rosy inflation view

Data: Federal Reserve Bank of St. Louis; Chart: Axios Visuals
Data: Federal Reserve Bank of St. Louis; Chart: Axios Visuals

The Federal Reserve continues to fret about inflation, and minutes released from the latest policy meeting showed that concern.

  • But the bond market's view is strikingly different, with prices implying the Fed's mission to crush inflation is pretty much accomplished.

Why it matters: The dance between the Fed and financial markets continues. The central bank remains unconvinced that inflation is on a consistent downward path, and is adamant rates won't be slashed this year.

  • Financial markets have the opposite expectation — and this divergence threatens to make the task ahead more difficult for the Fed, which wants financial conditions to remain tight to slow the economy.

What's going on: In the bond market, a key measure of inflation expectations paints a rosy picture — one in which prices speedily drop and settle at the Fed's 2% target.

  • "The market believes that inflation in the near future will not be that big of an issue," says George Goncalves, head of U.S. macro strategy at MUFG.

By the numbers: Treasury breakevens — the rate of future inflation suggested by the difference between yields on regular and inflation-protected bonds — suggest inflation will average roughly 2.2% over the next five years, well below last year's peak expectation of 3.6%.

  • Inflation-protected bonds track the Consumer Price Index, which runs hotter than the Personal Consumption Expenditure targeted by the Federal Reserve.
  • In theory, that means — if the bond market is priced correctly — inflation will be running at or even below the Fed's goal.

The intrigue: Top policymakers have publicly admitted they are puzzled by this sunny view. "I don’t quite know why markets are so optimistic about inflation," San Francisco Fed president Mary Daly said at a virtual event hosted by the American Enterprise Institute last month.

  • "I think it's clear we haven't turned the corner yet on inflation," Gita Gopinath, the No. 2 official at the International Monetary Fund, told the Financial Times in a new interview.

Between the lines: The bond market expects inflation to drop back to more tolerable levels, and investors expect the economic backdrop will be weak enough to nudge the Fed to slash rates this year. Officials have repeatedly said rate cuts are not on the horizon.

  • "No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023," minutes released on Wednesday said.

Yes, but: Bond traders don't have any special information that policymakers lack — and Treasury breakevens failed to predict the surge in inflation that took place in 2021.

The bottom line: The course of the economy in 2023 will depend on whether markets or the Fed turn out to have better foresight on inflation.

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