Federal Reserve Chairman Jerome Powell has managed to convince the bond market that he can maintain U.S. inflation close to the Fed's 2% target after he signaled late last year a reticence to raise interest rates further. Gathering clouds in the global economy suggest he will need to double down on his dovish rhetoric to bolster expectations further.
The five-year breakeven rate — the difference between the yield on a nominal fixed-rate bond and the real yield on an inflation-linked bond — was at 1.88% on March 18, rising from a more than two-year low of 1.49% on Jan. 2, according to data from the Federal Reserve Bank of St. Louis. The rate was above the Fed's 2% target for the majority of the period from February to October 2018. The 10-year breakeven rate was 1.96% on March 18.
Treasury 10-year yields have fallen 12 basis points to 2.59% since before the Fed's Jan. 30 meeting. The yield was at a more than seven-year high of 3.24% on Nov. 8, 2018.
The Fed is expected to keep rates unchanged during its March 20 meeting, continuing the dovish shift that began late last year and was given a further boost in its most recent meeting in January as rate increases were put on hold. Officials said after that meeting that muted inflation pressures played a role in their decision to put rate hikes on hold as they continue to monitor to what extent weaker global growth may spill over into the U.S.
The Fed's preferred inflation gauge stood at 1.9% in December 2018, just shy of the Fed's 2% target. However, Powell has described the weakness as transitory and has also said he is not concerned at the moment about the potential for recent wage gains to translate into meaningfully higher inflation.
Some economists have warned that the Fed may be too complacent on the threat of higher inflation. Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote in a note to clients that wage growth this year should "reach a pace which the Fed has been unable to ignore in the past." That would prompt the Fed to raise rates twice this year and potentially cause a shock among investors, who are largely assuming that the Fed will stand pat, he said.
Others are more skeptical that the historical relationship between tighter labor markets and prices, known as the Phillips curve, will reassert itself forcefully.
"We just haven't seen the data come through that would suggest that inflation is on the verge of picking up," said Curt Long, chief economist at the National Association of Federal Credit Unions.
In a Feb. 28 speech, Fed Vice Chairman Richard Clarida said market-based inflation expectations remain lower than they were in summer 2018, though he also noted the recent pickup in such measures. Overall, he said, inflation expectations look to be "at the lower end of a range that I consider to be consistent" with the Fed's 2% goal. The 10-year breakeven was at 1.84% on that day.
Fed Governor Lael Brainard, meanwhile, said in a March 7 speech that the decline in market-based inflation expectations "reinforces the evidence that the Phillips curve is very flat." Fed officials must remain alert to signs that inflation may spike, she said, but they must be "equally attentive to a risk of erosion in inflation expectations to the downside."
That mirrored recent comments from New York Fed President John Williams, who has called on the Fed to consider switching its inflation targeting approach as it reviews its monetary policy framework this summer. Among the options on the table is switching to strategies in which the Fed deliberately allows for an inflation overshoot to make up for its past deviations from the 2% target. Powell has said those strategies "deserve serious attention" but that any switch would need to clear a high bar.
Attempting a switch that "will actually increase inflation expectations without letting inflation approach unreasonable levels will be a difficult task for the Fed," wrote Mark Capleton, a rates strategist at Bank of America Merrill Lynch, but the debate may help push up markets' inflation outlook.
"Whatever the final choice, and even if policy does not ultimately change, we think these discussions and related headlines should support higher inflation expectations," Capleton wrote.
For now, though, analysts say the recent lack of inflation pressures has helped keep a lid on U.S. bond yields, as have the continued worries about a slide in global growth.
Bond yields also slipped slightly in France, Germany, Spain and Italy since the last Fed meeting. During that time window, the European Central Bank cut its 2019 growth forecast from 1.7% to 1.1%, delayed a possible rate hike to the end of this year and announced the restart of a program to offer cheap loans to eurozone banks.
The Bank of Canada is also keeping rates flat for now as officials monitor signs of weaker growth. Yields on 10-year Canadian sovereign bonds have fallen 23 basis points to 1.73% since the last Fed meeting.