What is break-even inflation?
We looked at PCE inflation and its importance in the previous article. Policymakers at the Federal Reserve also look at market-based inflation expectations while determining the course of monetary policy. In order to understand these expectations better, we need to outline the concept of break-even inflation.
The break-even inflation rate is used to assess the inflation expectations 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.
Real yield is nominal yield adjusted for inflation. Hence, 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).
Understanding the graph
The graph indicates that market participants are expecting inflation to remain lower than 2% over five- and ten-year periods. Importantly, after having risen in November 2015, inflation expectations have fallen for two consecutive months in December 2015 and January 2016. This downturn has been primarily driven by a fall in crude oil prices.
According to data from the EIA (U.S. Energy Information Administration), Cushing, Oklahoma, West Texas Intermediate prices fell to $26.19 per barrel on February 11, 2016, the lowest since early May 2003. This hurt the stocks of oil companies such as Kinder Morgan (KMI), Marathon Oil (MRO), and ConocoPhillips (COP).
Why monitoring break-even inflation is important
Managing inflation expectations is as important for policymakers as keeping PCE inflation in check. If low inflation expectations get embedded into the Market, they’ll be reflected in asset prices. Though central bankers are not responsible for managing asset prices, a mismatch in expectations and policy action could result in undesired volatility.
For bond mutual fund investors (BGNAX) (ADFAX), this indicator can give insight into what the Market is thinking about inflation. Combined with the actual change in PCE inflation, this indicator can help investors gauge policy moves and give them indications about how to realign their bond investments.
Bond mutual fund investors should also look at the labor market to better understand the state of the economy and its readiness for further rate hikes. Let’s look at that in the next article.