As my colleague Rick Rieder discusses in a recent post, the latest employment report tells us that the economy may be stronger than previously thought. Still, the Fed may be cautious on raising rates if inflation isn’t pushing above their target levels. Recall that the Fed operates under a dual mandate: to encourage economic growth and to also keep inflation contained. Subdued inflation would give the Fed the breathing room to keep short term interest rates low for a longer period of time, even in the face of an improving jobs market. In a sense, you can think of inflation as the cost of an accommodative monetary policy. Low interest rates should boost growth over time, but at the same time they risk triggering a rise in inflation. If inflation remains low, then the cost of low interest remains low.
For the most part, inflation was well contained over the past year, running right around the Fed’s target of 2% from April to July. In August however, the consumer price index (CPI) unexpectedly fell 0.2% from July’s level, despite economists’ expectation of no change. This was the first time that CPI had been negative in a given month since April 2013. Although inflation then rebounded +0.1% in September, it still remains at historically low levels.
Does this mean that inflation is beginning to decline? To get a sense let’s take a look at the breakeven inflation rate. This is the amount of inflation that investors have priced into the market in the future; it is measured by looking at the difference in yields on Treasuries and TIPS. We see that the expected level of inflation over the next 10 years has declined from 2.27% on July 31 to 1.90% on October 28th. If we look at shorter term inflation expectations, we see an even larger difference, as 2-year breakeven inflation has declined from 1.52% on July 31st to 0.88% on October 28th.*