Markets are less sure the Fed and RBA will hit their inflation targets
Market measures of expected inflation have picked up, which is unusual this late in the cycle.
Market measures of expected inflation have recently picked up in the US and Australia, which is unusual this late in the cycle. The increases could prove temporary if economies soon roll over, but suggest that markets are less sure that the Fed and RBA will successfully contain inflation
The sharp rise in world bond yields over the past couple of years has been driven by higher real yields, but there has recently been an unusual pick-up in market measures of expected inflation.
In the US, expected inflation – as represented by the 5-year/5-year forward rate – is now at about 2½% based on both Federal Reserve DKW model estimates that adjust for TIPS liquidity and inflation risk premia and inflation swaps data. [1]
It is unusual for expected inflation pick up this late in a rate hike cycle and the rise may prove temporary if the economy finally rolls over and/or if higher expected inflation partly reflects the risk of a broader conflict in the Middle East.
Nevertheless, this is the highest level of expected inflation in several years and suggests that the market is less certain that the Fed’s 5¼-5½% funds rate will successfully return inflation to the 2% target over the medium term.
In Australia, there are no equivalent market measures that adjust for inflation-indexed bond liquidity and inflation risk premia, but the expected inflation rate derived from inflation swaps data has also picked up recently to almost 3%, which is the highest level in several years.
This 5-year/5-year forward measure of expected inflation is still within the RBA’s 2-3% inflation target band, but its recent increase suggests that the market is less sure that the current RBA cash rate of 4.1%, together with an expected rate hike next week, will see the bank hit the 2½% midpoint of the target band.
While the RBA still officially targets a 2-3% range for inflation, the yet-to-be-finalised Statement on the Conduct of Monetary Policy - which is the formal agreement on the operation of monetary policy between the treasurer and the RBA board - could emphasise the importance of the 2½% midpoint given that the recent RBA review explicitly recommended that policy-makers "should aim for the [2½%] midpoint of the inflation target in order to maximise the chance that the target is met and best anchor inflation expectations”.
Note:
[1] These estimates have been adjusted for the average c0.3pp pre-COVID wedge between CPI inflation, which matters for market pricing of inflation compensation, and PCE inflation, which is targeted by the Federal Reserve.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy, contributing to the investment decisions of the firm. Kieran has long experience as a macroeconomist in both the private and public sectors. He has worked most recently as Chief Markets Economist for National Australia Bank and was previously Chief Economist, Australia and New Zealand, for Barclays Bank and ABN Amro Bank/RBS. Kieran also worked as Principal Adviser on the macroeconomy and budget policy in the Commonwealth Treasury and Director of Forecasting.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...
Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...
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