Forget CPI. This Market Indicator Says Inflation May Stay Above 2% for Years.

As investors and traders brace for the latest consumer-price index (CPI) report, one market indicator is sending a clear message: inflation may remain above the Federal Reserve's 2% target for years. The five-year breakeven inflation rate, a measure of average expected inflation over the medium term, has been hovering above its 50- and 200-day moving averages since late October 2024, suggesting that investors anticipate higher inflation in the coming years.

This persistent elevation of the five-year breakeven inflation rate can be attributed to several factors. First, consumer expectations data from the University of Michigan indicates that inflation could stay above the Fed's 2% target for an extended period. Second, uncertainty surrounding President Trump's policy proposals, such as tariffs, is raising the stakes and contributing to the elevated breakeven inflation rate. Lastly, the inflation risk premium embedded in the breakeven inflation rate has been a significant driver of the movement in longer-term inflation expectations, suggesting that the balance of risks to the inflation outlook has been one of the main factors contributing to the persistent elevation of the breakeven inflation rate.

Market participants' expectations, as reflected in the five-year breakeven inflation rate, influence the pricing of other financial instruments and the transmission of monetary policy to the real economy. The breakeven inflation rate affects the yield curve, which is a crucial input in the pricing of various financial instruments, including mortgages and corporate bonds. When the breakeven inflation rate is high, it implies that investors expect higher future inflation, which in turn increases the expected real yield on nominal bonds. This higher real yield makes borrowing more expensive for both households and businesses, which can lead to a decrease in consumption and investment, respectively. Conversely, a low breakeven inflation rate implies lower future inflation expectations, which reduces the expected real yield on nominal bonds, making borrowing cheaper and potentially stimulating economic activity.

Moreover, the breakeven inflation rate influences the pricing of inflation-linked bonds, which are designed to protect investors from the effects of inflation. The higher the breakeven inflation rate, the more expensive these bonds become, as investors demand a higher premium to compensate for the expected loss of purchasing power. This can lead to a decrease in demand for these bonds, which in turn affects the pricing of other financial instruments, such as nominal bonds.

Lastly, the breakeven inflation rate can influence the exchange rate, which is a key factor in the transmission of monetary policy to the real economy. A high breakeven inflation rate can lead to a depreciation of the currency, as investors seek higher returns in other currencies with lower inflation expectations. This depreciation can make imports more expensive, which can lead to an increase in domestic inflation. Conversely, a low breakeven inflation rate can lead to an appreciation of the currency, which can make exports more competitive and potentially lead to a decrease in domestic inflation.

In conclusion, the persistent elevation of the five-year breakeven inflation rate above the Federal Reserve's 2% target can be attributed to a combination of factors, including consumer expectations, policy uncertainty, and global concerns about weak aggregate demand. Market participants' expectations, as reflected in the breakeven inflation rate, play a crucial role in the pricing of other financial instruments and the transmission of monetary policy to the real economy. As investors and traders continue to monitor the latest CPI report and other economic indicators, the five-year breakeven inflation rate will remain an essential market indicator to watch for signs of long-term inflation trends.