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Is Breakeven Inflation Indicating a Deferred Rate Hike?

July 2015 Minutes Show an Uncertain Fed

(Continued from Prior Part)

What is breakeven inflation?

Market-based inflation expectation is an important metric that policymakers examine while assessing the path of inflation. In order to understand these better, we need to outline the concept of breakeven inflation.

The breakeven inflation rate is used to assess the inflation expectations of market participants. The graph below represents the difference between the nominal yield on a fixed-rate bond of a certain duration and the real yield on an inflation-indexed bond of the same maturity and credit quality.

The real yield is a nominal yield adjusted for inflation. So, the five-year breakeven inflation rate is the difference between the nominal yield on the five-year Treasury note and the real yield on five-year TIPS (Treasury Inflation Protected Securities).

What does the graph indicate?

The graph indicates the inflation expectations of market participants, showing that even investors are expecting inflation to remain lower than 2% over five- and ten-year periods. This, combined with expectations of moderate economic growth, does not paint a very positive picture for policy normalization.

One of the statements from the July 2015 minutes that the market addressed was: “The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.”

This statement implies that if the economy were to experience any untoward developments, neither the central bank nor the government would be equipped, policy-wise, to help the economy. This could imply that the Fed could wait before taking any rate action.

A deferred rate hike would be welcomed by investors in ETFs like the Vanguard Total Bond Market ETF (BND), the iShares Core US Aggregate Bond ETF (AGG), and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). Plus, equity investors, especially utility stocks (D) (SO) (NEE), would not mind a delay.

From inflation, let’s move on to the labor market and see what the July 2015 minutes had to say about its status.

Continue to Next Part

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