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Simple twist of FAIT – Fed scents inflation victory: McGeever

The Fed will not admit it yet, but it may already have won the battle against inflation.

That is the signal coming loud and clear from inflation-linked bonds, which show inflation expectations over the next couple of years at their the lowest since 2020 and virtually back down to the Fed’s target of 2%.

In that light, the Fed’s interest rate hiking cycle is close to an end. Rates futures market pricing now points to one more quarter-point increase next month, maybe another in May, then 50 basis points of easing in the second half of the year.

Figures on Thursday showed that the headline annual rate of consumer price inflation slowed to 6.5% in December. That is still well above the Fed’s target, but the speed and direction of travel since June’s four-decade high of 9.1% is clear.

What’s more, consumer prices fell month-on-month for the first time since May 2020. Given the overwhelmingly negative base effects from oil, energy and commodity prices, disinflationary forces are only likely to intensify.

U.S. breakeven inflation rates – the gap between yields on inflation-protected Treasuries and regular notes – reflect this.

The two-year breakeven inflation rate this week fell as low as 2.02%, the lowest since December 2020. It rose to 2.12% after the December inflation data, but that is of little significance when you recall that it was nudging 5% less than a year ago.

Five-year and 10-year breakevens also spiked a little after the inflation numbers but remain anchored around 2.25%. They too got close to 2% late last year.

Measures of market-based inflation expectations like breakevens and forwards are far from perfect. They are distorted by the risk premiums embedded in them and relatively thin liquidity.

But they are still useful guides, and the overarching message is evident.

“The market-implied path of CPI continues to show a sharper reversal than our Econ team and certainly the Fed projections reflect,” Bank of America strategists wrote on Thursday, referring to breakeven rates.

The most recent median forecasts from Fed officials, published in December, for headline PCE inflation this year, next year and 2025 are 3.1%, 2.5% and 2.1%, respectively. They will be updated in March.

The Fed’s long-standing inflation target has been 2%, but since August 2020 it has pursued a “flexible average inflation targeting” (FAIT) framework of achieving 2% inflation “over time,” an undefined period of time.

This flexibility – and some would say, confusing ambiguity – allows for inflation to run “moderately above 2 percent for some time” following spells when it persistently undershoots the target, as was the case for the post-COVID period and most of the time from the Great Financial Crisis through March 2020.

The 2021-22 energy and supply shock obviously pushed inflation much higher than levels “moderately above” 2% but these forces are rapidly reversing. This will drive down the average inflation rate, whatever the time horizon.

A wide range of commodities, whose price surge led to the highest inflation in 40 years – lumber, natural gas, oil, wheat, copper and more – are cheaper today than a year ago. Some are significantly cheaper.

Rick Rieder, chief investment officer of global fixed income and head of global allocation investment at BlackRock, the world’s largest asset manager, notes that base effects from energy alone will substantially reduce inflation further.

“Even if energy costs remain near current levels through the middle of the year, the net impact would be a -1.5 percentage point cooling in headline CPI year-over-year relative to its latest rate of 6.5%,” Rieder wrote on Thursday.

Fed officials will not want to declare victory on inflation until it is much closer to 2%, and erring on the hawkish side in public will help anchor inflation expectations. But the peak in interest rates is drawing into view.

Federal Reserve Bank of Philadelphia leader Patrick Harker indicated that he may be softening his view that rates need to go above 5%, and Richmond Fed President Tom Barkin said the Fed can now be “more nuanced” in its policy steps.

The Fed’s policy rate is currently in a 4.25%-4.50% range. Interest rate futures markets point to a terminal rate of around 4.90% by the middle of this year before the Fed starts easing.
Source: Reuters (By Jamie McGeever in Orlando, Fla. Editing by Matthew Lewis)

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