A further widening of inflation break-evens complicates things for the Fed even if it remains committed to its wait and see strategy that only decides to act when the evidence of higher inflation is clear (are we there yet)?
Risk premiums become prices in plain sight and they become a statement on expectations of the mean and variance of inflation. The prices also help satisfy the market’s (almost insatiable) need for narrative.
One such narrative might read “inflation break-evens are a Fed credibility metric”. These narratives serve to reinforce the broad market consensus. In circular fashion, what we think helps determine prices, which in turn tell us what to think and what to believe.
Staring at quickly rising, market determined b/e levels will not be comfortable for the Fed. In this circumstance, the already prominent chorus of professionals asking the Fed to keep its options open during a period of uncertainty would increase in number. Market prices matter.
If demand for inflation protection far outstrips the supply of it, the price for protection can gap higher. Investor views could be quickly shaped and updated to include a wide array of outcomes.
What does “behind the curve mean?” In its traditional meaning, it is a Fed facing inflation data that requires it to react even if it would prefer not to. There is a more nuanced risk here as well.
The longer the Fed ignores the real time price discovery of inflation risk premium, should it reach a further elevated level, the more out of step it could conceivably be if it turns out the Fed’s hopes for transitory are not fulfilled.
It is not a leap to have market prices force the Fed’s hand. Imagine the scenario in which expectations feed into price so strongly that the absence of tightening action from the Fed becomes a de facto ease.
The Fed’s hard-fought inflation credibility, 25 years in the making, is put at risk. There’s no obvious way out for the Fed if the feedback loop between data and expectations is direct. Market prices can move quickly.
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The anticipation of high realized inflation and uncertainty around it impacts inflation risk premiums. This is very important because at some point the Fed cannot ignore the discovery of prices in real time, it’s “wait and see” strategy notwithstanding.
A further widening of inflation expectations complicates things for the Fed even if it remains committed to its wait and see strategy that only decides to act when the evidence of higher inflation is clear.
Risk premiums become prices in plain sight and they become a statement on expectations of the mean and variance of inflation. The prices also help satisfy the market’s (almost insatiable) need for narrative. One narrative might read “inflation b/e's are a Fed credibility metric”.