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.
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 such a circumstance, the already prominent chorus of professionals asking the Fed to keep its options open during a period of uncertainty would increase in number.
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.
All of this is to say that market prices matter. The longer the Fed ignores the 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. Market prices matter.
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