Investors Brace for Inflation as Fed Holds Firm

Treasury market investors are betting that inflation is going to cool off significantly in the near future. However, Federal Reserve policy makers are not as confident that this will happen.
The tension between markets and the central bank is unlikely to be resolved until one side is proven correct.
The Labor Department reported on Thursday that consumer prices fell by 0.1% in December, when compared to the previous month of November. This puts overall prices at 6.5% above where they were during the same time last year. This is still considered high, but it is a decrease from the 9.1% rate that was seen in June. Core prices, which exclude food and energy items in order to get a better understanding of inflation, rose by 0.3% from November to December. They are also up 5.7% from this time last year. In September, the core prices hit a high of 6.6% compared to the previous year.
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A lot of the recent cooling in prices is concentrated in categories for which the Fed and many economists had earlier argued that price increases would be transitory. Seasonally adjusted gasoline prices fell 9.5% in December from November, subtracting nearly 0.4 percentage point from the monthly change in overall prices. Prices for used cars and trucks slipped 2.5%, subtracting about 0.1 point.
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There is likely more cooling to come in the near future. Used-vehicle prices are still well above prepandemic levels, but are expected to slip further as the supply-chain problems that hit new-car production continue to ease. The Labor Department's gauge of rents, which it uses to calculate overall housing costs, continues to rise, but with private data providers such as Zillow and RealPage showing prices on new leases dropping, official housing-price measures are expected to moderate in the coming months.
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The break-even rate on Treasury inflation-protected securities (TIPS) implies that Treasury investors expect the Labor Department's measure of inflation to average around 2.2% over the next five years. Similarly, the Fed's calculations of break-even rates over shorter time horizons imply that, as of last Friday, investors expect annual inflation of about 2% over the next two years.
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The Federal Reserve's preferred measure of inflation from the Commerce Department tends to be lower than the Labor Department's: since 1960, a 2% annual increase in the Labor Department's consumer prices has been associated with a 1.8% gain in the Commerce Department's. So, with the caveat that more factors than just inflation expectations can affect TIPS prices, investors seem to expect that the Fed will eventually fall short of its 2% inflation target.

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After being burned by inflation over the past year, Fed policy makers are unlikely to put too much stock in market forecasts. They are concerned that a tight labor market is leading to higher inflation in the services sector, which is not transitory. Thursday's report showed that services prices excluding shelter costs were up 7.4% from a year earlier in December. This is below September's 8.2% rise, but it needs to come down further before the Fed is convinced inflation is under control.
Investors believe that inflation will soon start to decline, and that policy makers will end up raising rates by less than they expect. Policy makers may be concerned that this optimism could lead to inflationary pressures in the economy, making the fight against inflation more difficult. Financial markets will be influenced by how this debate unfolds in the coming months.