Navigating the Shifting Sands of Inflation: The Fed's Delicate Balancing Act

As the Federal Reserve continues its battle against inflation, bond investors are facing a new challenge – the risk of consumer price growth slowing too much. With the August inflation report looming, the market is grappling with the possibility that the inflation rate could fall below the Fed's target, potentially forcing policymakers to keep borrowing costs low for an extended period, limiting their ability to combat economic downturns.

Inflation Expectations: A Delicate Equilibrium

The Inflation Outlook: A Shifting Landscape

The bond market is signaling a growing concern that the inflationary surge may be fully behind us. The 10-year breakeven rate, a gauge of expected consumer price index increases, has fallen to 2.02%, the lowest level since 2021. This suggests that investors believe inflation will average below the Fed's 2% goal over the next decade, as the personal consumption expenditures price index typically runs about 40 basis points below the consumer price index.The decline in the breakeven rate is driven by the yields on nominal bonds falling faster than those on inflation-protected securities (TIPS), which are typically less traded than regular bonds. Strategists also note that technical factors, such as low liquidity in US inflation-linked debt and a sharp drop in oil prices, are contributing to the shift in market sentiment.

The Fed's Dilemma: Balancing Inflation and Employment

The bond market's pricing reflects a growing belief that the Fed may have been too slow to ease policy, potentially risking an economic downturn. Interest rate swaps show that traders have fully priced in a 25-basis-point rate cut at the September 18th meeting, with a 20% chance of a more aggressive half-point reduction.This debate highlights the Fed's delicate balancing act between its dual mandate of price stability and maximum employment. Policymakers have long argued that persistently low inflation can be as detrimental to the economy as elevated prices, as it would force them to keep borrowing costs too low for too long, reducing their ability to fight off economic downturns.

The Shorter-Term Inflation Outlook: Cause for Concern

The bond market's pricing also suggests an even more dire outlook in the shorter term. Inflation swaps contracts indicate that traders are betting on consumer prices rising only about 1.7% over the next 12 months, a sharp slowdown from the expected 2.5% increase in the August report and the 2.9% pace in July.This pricing reflects the Treasury market's assessment of a higher risk of a "hard landing" for the economy, where the Fed's aggressive rate hikes lead to a significant economic slowdown or recession. The absence of an inflation risk premium in the market suggests that investors are not currently concerned about the prospect of persistently high inflation.

The Risks of Overshooting and Undershooting the Inflation Target

The bond market's reaction highlights the delicate balance the Fed must strike in its fight against inflation. On one hand, policymakers are wary of allowing inflation to become entrenched, as that could erode the central bank's credibility and limit its ability to respond to future economic shocks. On the other hand, moving too aggressively to bring down inflation could risk tipping the economy into a recession, with potentially severe consequences for employment and overall economic well-being.As Tim Duy, chief US economist at SGH Macro Advisors, notes, "Market participants are sensing that the inflationary surge is now fully over, and there's some chance here now, with the balance of risk being shifted to the employment mandate, that the Fed undershoots its inflation target." This underscores the importance of the Fed's communication and its ability to navigate this complex landscape effectively.