Traders are pricing in a US inflation rate heading for 8.6% through March and April, before Federal Reserve officials have a chance to offer a possible 50% interest rate hike. basis points in May.
Derivative-like instruments known as fixes imply that the consumer price index’s year-over-year gain for March and April will be 8.6%, up from a 40-year high. 7.9% in February. Only the March reading will be available to Fed officials at the time of their May 3-4 meeting; April data will not be released until the following week.
From a timing standpoint, that puts policymakers in a tough spot. Now that the Fed chairman Jerome Powell has come this week to entertain the idea of a half percentage point increase as early as May, inflation expectations may be taking hold.
The 10-year breakeven rate, which reflects investors’ inflation outlook, hit an all-time high of 3.03% on Thursday, while the 5-year breakeven rate also hit a record earlier in the day. And inflation swaps, another measure of where investors see inflation headed, are soaring on a one-year forward basis. All of this comes after a measure of public opinion. short-term inflation expectations he broke his own record again last month.
“The problem in the hands of the Fed is less about the economy and more about psychology: society has no problem raising prices,” said Gang Hu, a TIPS trader at New York hedge fund WinShore Capital Partners. “So I personally think the Fed missed an opportunity earlier this month to make a surprise and awe move on society’s inflation psychology.”
The Fed last week made its first rate hike in four yearsraising the fed funds rate by 25 basis points.
“Unfortunately, this might have been the time when the market and society needed a show of shock and amazement that the Fed is still very focused on keeping inflation down,” Hu said by phone on Thursday. “Raising rates by 25 basis points, without quantitative adjustment, has almost added fuel to the fire. Main Street is saying, ‘We can raise prices however we want, regardless of the competition.’ So far, it’s correct.”
The table below reflects current expectations for annual headline CPI readings to remain between 7% and 8% through October; that’s a longer stretch of readings over 7% than was expected just three weeks ago.
Here’s what the chart looked like on March 3, before the Fed’s March 16 decision to raise rates by a quarter point:
Based solely on inflation swaps, “the market says inflation is likely to remain well above the Fed’s forecast for next year,” said Michael Pond, head of global inflation-linked research at Barclays. “If the market is okay, the Fed probably has to be more aggressive than it has already signaled.”
Fortunately for policymakers, the change in inflation expectations that may be occurring has not strongly impacted the medium-term outlook, and that is a consideration that may be more important, he said. One of the central bank’s favorite gauges of the inflation outlook, known as the 5 years, 5 years ahead breakeven inflation rate, still hovered around 2.3% as of Wednesday.
That move suggests “the market believes the Fed still has credibility and will eventually be able to achieve its 2% inflation target,” Pond said by phone on Thursday. “As long as the market and consumers in general believe that inflation will come down, then the Fed can have a little patience. But eventually the market may lose faith in the Fed if it leaves inflation high for too long.”
On Thursday, Treasury yields moved mostly higher, with the 10-year rate TMUBMUSD10Y,
hovering around 2.3%, as the main US stock market indices DJIA,
rose higher in afternoon trading.