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What Do Market-Based Inflation Expectations Mean?

The Relationship between Rate Hike Timing and Economic Indicators

(Continued from Prior Part)

Market-based inflation expectations

In the previous article, we saw the path that survey-based inflation expectations are portraying for inflation. Market-based inflation expectations are also an important metric that monetary policymakers look at while assessing the path of inflation. In order to understand these metrics better, we need to outline the concept of break-even inflation.

Break-even inflation

The break-even inflation rate is used to assess the inflation expectation of market participants. The graph above 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 the nominal yield adjusted for inflation.

So, the five-year break-even 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).

The message

Unlike consumers, market participants have very low hopes about inflation reaching the 2% level, even in the next five years. The worrying factor is that inflation expectations have fallen in June 2015.

This can have important implications on monetary policy. If market participants do not expect inflation to close in on the 2% level even in the coming five years, it could mean a very gradual path to monetary policy normalization as far as rate hikes are concerned. It would not stop the first rate hike, but it would make the wait for successive rate hikes longer.

This may help to lessen the worries of fixed income investors—both direct and in ETFs like the Vanguard Total Bond Market ETF (BND) and the iShares Core US Aggregate Bond ETF (AGG)—who may be worried about a sharp run-up in yields once the rate hike is affected. Investors in equities, as well as utility stocks (D) (SO) (NEE), may also find this to be comforting.

From inflation, we’ll move to the labor market and associated metrics in the next article. Let’s look at their potential impact on an impending rate hike in the US.

Continue to Next Part

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