Inflation Battle May Not Be Over Yet, as Investors See Risks

Concerns about inflation are resurfacing in financial markets, as recent data suggests that price pressures may linger above the Federal Reserve's 2% target for longer than previously anticipated. On Tuesday, inflation swaps and Treasury Inflation-Protected Securities (TIPS) indicated that inflation might remain modestly elevated for years to come. This is a shift from earlier in the month when both of these market-based measures of inflation expectations were trending downward.

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One key measure of inflation expectations, the five-year breakeven rate, has risen recently. The breakeven rate reflects the difference between the yields on nominal Treasuries and TIPS of similar maturity, providing insight into what investors expect inflation to average over the next five years. As of the latest data from the St. Louis Federal Reserve, the five-year breakeven rate stood at 2.04%, after hitting a nearly four-year low of 1.86% earlier in the month. This shift suggests that investors are becoming more cautious about the possibility of sustained inflation.

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A similar trend is visible in the market for inflation swaps, which have a reputation for being more reliable in predicting future inflation pressures. On Tuesday, one-year swaps tied to the Consumer Price Index (CPI) showed expectations for inflation to be 2.028% one year from now. Meanwhile, five-year swaps indicated a rate of 2.333%. Both of these figures have increased from their September lows, signaling that market participants are bracing for the possibility that inflation may not subside as quickly as hoped.

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In addition to market-based measures, consumers are also expecting higher inflation in the future. According to the Conference Board's latest consumer confidence survey, average 12-month inflation expectations rose to 5.2% in September. This increase highlights growing concern among the public that price pressures could persist in the months ahead.

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The rising inflation expectations in financial markets and among consumers are leading traders to question whether the Federal Reserve may have shifted its focus too quickly from inflation to the labor market. While inflation peaked in 2022 at more than 9% year-over-year, it has since moderated, allowing the Fed to reduce its policy-rate target by 50 basis points last week. However, this easing in monetary policy may have introduced new risks, as some traders worry that inflation could reignite if the Fed takes too relaxed an approach.

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Tim Murray, a capital markets strategist at T. Rowe Price, commented on the delicate balance the Fed is trying to maintain. "They’d rather get inflation down gradually and avoid a recession, but embarking on that path means there’s definitely a risk that inflation not only takes longer to subside, but could reignite as we get into the latter part of the year," he said in an interview with MarketWatch.

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This situation is reminiscent of the 1970s when the Federal Reserve prematurely declared victory over inflation, only to see it come roaring back. Although Murray does not expect a repeat of that era, he acknowledged that the risk remains. Some Fed officials share similar concerns. For example, Fed Governor Michelle Bowman, who was the sole dissenter in last week's rate cut decision, argued that such an aggressive move might unnecessarily fuel inflationary pressures.

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Other analysts, like Steven Ricchiuto, chief U.S. economist at Mizuho, have voiced concerns about the Fed’s credibility. In commentary shared with MarketWatch, Ricchiuto warned that accepting a higher inflation rate in exchange for a tighter labor market could become a slippery slope, particularly in an environment where fiscal responsibility has been largely ignored. He cautioned that even a slight tolerance for a higher inflation rate could erode the Fed's hard-won credibility.

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The debate over inflation and the Fed's approach is far from settled. Investors are eagerly awaiting more data, particularly the release of the Federal Reserve’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) Price Index, which is due out on Friday. Earlier this month, the CPI data showed that core inflation, which excludes volatile food and energy prices, was stickier than expected in August. Housing costs, in particular, rose at the fastest monthly pace so far this year, contributing to the higher inflation readings.

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Another factor contributing to the rise in inflation expectations is the recent rebound in commodity prices. Gennadiy Goldberg, a rates strategist at TD Securities, noted that much of the increase in inflation swaps could be attributed to rising prices for commodities like crude oil. On September 10, the West Texas Intermediate crude futures contract settled at $65.75 per barrel, its lowest level since December 2021. However, by Tuesday, the price had recovered to over $71 per barrel. This recovery in commodity prices, combined with aggressive stimulus measures announced by China's central bank, has contributed to the upward pressure on inflation expectations.

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Despite the rise in commodity prices and inflation expectations, Goldberg remains cautiously optimistic. "I think inflation is still trending down, but the question on everyone’s minds is ‘how quickly?’" he said.

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So far, U.S. equity markets have taken the rise in inflation expectations in stride. The S&P 500 rose 14 points, or 0.3%, to 5,732 on Tuesday. The Nasdaq Composite gained 100 points, or 0.6%, closing at 18,074. Meanwhile, the Dow Jones Industrial Average added 84 points, or 0.2%, reaching 42,208. Despite these gains, U.S. futures pointed to modest losses at the open on Wednesday, as investors reassessed the outlook for inflation and monetary policy.

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As the week progresses, all eyes will be on the PCE Price Index and other economic data releases to gauge whether inflation is truly under control or if it may pose a larger risk to the economy going forward.

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