Following the shocks of the pandemic, we reconstituted our economic framework around the idea of a regime change in interest rates and inflation that can best be understood as higher for longer.
That framework has served our economic analysis and forecasting quite well.
Now, we may be entering the second phase of that regime change with respect to the development of inflation that is structurally higher.
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Because breakevens, or market-based measures of expected inflation, embed both expected inflation and an inflation risk premium, we think this is an appropriate time to look at the possibility that inflation and interest rates are starting a new phase of regime change.
Consider the 5, 10 and 30-year breakevens since the start of the war. Those measures of expected inflation, which are derived from actual money on the table as opposed to surveys, have been rising.
Five-year breakevens since Feb. 27 have increased from 2.445% to 2.72%, the 10-year from 2.25% to 2.5% and the 30-year from 2.19% to 2.3%.
It’s not just the breakevens, either. With inflation approaching 4% and the Federal Reserve not having met its 2% target for five years, one must acknowledge that investors are resetting inflation expectations higher.
Such a move signals that the Fed’s current monetary policy may be too loose given current inflation dynamics and the risk to the economic outlook.
This is why we expect that the Fed will remove the easing bias in the most recent Federal Open Market Committee statement at its policy meeting in June.
Kevin Warsh is about to begin his tenure as Federal Reserve chair with what some believe is a mandate from the president to cut rates.
But the recent rise in market-based breakeven inflation rates strongly implies that Warsh and the FOMC will have to prepare for the chance that inflation will continue to rise and that the Fed will have to shift its policy.
In his confirmation hearing, Warsh testified that “inflation is a choice.” He may get the chance to prove he actually believes it.
