Lesson 4
Inflation Expectations
Track the 5Y5Y forward breakeven. If it stays around 2-2.5%, the Fed has flexibility. If it rises toward 3%, the Fed MUST get hawkish to prevent a spiral. The 5Y5Y is your warning indicator for aggressive Fed action.
Actual inflation matters, but EXPECTED inflation might matter more. Here's why expectations are the key variable for Fed policy.
The Self-Fulfilling Prophecy:
If people expect 5% inflation:
- Workers demand 5% raises
- Companies raise prices 5% to cover wage costs
- Landlords raise rents 5%
- Inflation actually becomes 5%
Expectations become reality. This is why the Fed obsesses over keeping expectations 'anchored' at 2%.
When Expectations Become 'Unanchored':
If long-term inflation expectations rise significantly above 2%, the Fed has a major problem:
- The inflation-expectation spiral begins
- Each round of wage increases leads to price increases
- The spiral accelerates
Measuring Expectations:
Survey-Based:
- University of Michigan Consumer Survey
- NY Fed Survey of Consumer Expectations
Market-Based:
- 5Y Breakeven: 5Y Treasury yield minus 5Y TIPS yield
- 5Y5Y Forward: Expected inflation 5-10 years out (most important!)
The 5Y5Y Forward:
- Normal: 2.0-2.5%
- Concerning: > 2.7%
- Crisis: > 3.0%
If 5Y5Y rises above 2.7%, expect the Fed to get more hawkish regardless of current inflation.
Check your understanding
Lesson Quiz
Quiz Check
The 5Y5Y forward breakeven is at 2.8% and rising. What does this tell you about Fed policy?