The Fed’s new leader contends with rising inflation
Key takeaways:
Following the shocks of the pandemic, we reconstituted our economic framework around the idea of a regime change in interest rates and inflation that can best be understood as higher for longer.
That framework has served our economic analysis and forecasting quite well.
Now the economy may be entering the second phase of that regime change: inflation that is structurally higher.
Consider the rise in five-, 10- and 30-year breakevens since the start of the Iran war. Those market-based measures, which reflect both expected inflation and an inflation risk premium, are derived from actual money on the table as opposed to surveys.
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From Feb. 27 through May 15, five-year breakevens increased from 2.45% to 2.71%, the 10-year from 2.25% to 2.5%, and the 30-year from 2.19% to 2.3%.
It’s not just the breakevens. With inflation approaching 4% and the Federal Reserve not having met its 2% target for five years, investors are resetting inflation expectations higher.
Such a move signals that the Fed’s current monetary policy may be too loose given current inflation dynamics and the risk to the economic outlook.
This is why we expect that the Fed will remove the easing bias from its statement at its June 16−17 policy meeting.
Kevin Warsh has just started his tenure as Federal Reserve chair with what some believe is a mandate from the president to cut rates.
But the recent rise in market-based inflation breakevens strongly implies that Warsh and the FOMC must prepare for inflation to continue to rise and that the Fed will have to shift its policy.