Traders Sense An Inflation-Constrained Fed Is Back

Why the change? It’s hard to read the mind of markets, but some recent developments around the Fed’s dual mandate of maximum employment and stable prices are noteworthy. As to the first, the economy no longer seems to be tipping into recession and dragging the labor market down with it. Widespread recession fears in 2022 seemed to be vindicated when the unemployment rate began to climb a year later, peaking at 4.3% in July from a low of 3.4% in April 2023. That prompted the Fed to pay at least as much attention to the labor market as to inflation, ultimately leading it to begin lowering rates.

A recession is nowhere in sight, though. The economy grew at an annual rate of about 3% after inflation during the second and third quarters, and the Atlanta Fed’s tracker of gross domestic product estimates growth of 2.4% this quarter. The unemployment rate has also ticked down to 4.1% since July, despite some noisy monthly jobs numbers along the way. That probably explains why the 10-year Treasury yield has moved modestly north of the two-year yield, right sizing an inverted yield curve that many had taken to signal the risk of recession. As it turns out, the labor market may not need as much help as previously anticipated.

Now consider the other side of the Fed’s mandate. The inflation rate is careening toward the Fed’s 2% target, but getting there may be harder after the presidential election. Donald Trump’s spending plans could add up to $15 trillion in deficits over the next 10 years, according to the nonpartisan Committee for a Responsible Federal Budget.

That’s a huge amount of fiscal stimulus on top of the $11 trillion in total deficits since 2020 that contributed to the recent bout of consumer price increases. Never mind Trump’s promise to expand tariffs or deport undocumented workers, or the too-little-mentioned size of the Fed’s balance sheet, which has swelled to $7 trillion, a heap of monetary stimulus that would have been unthinkable before the Covid pandemic. All of that is potential food for inflation.

Other parts of the bond market certainly seem to think so. The five-year breakeven rate — the difference in yield between nominal and inflation-adjusted five-year Treasuries, which is a good gauge of inflation expectations — is up to 2.5% from closer to 1.8% in September. The 10-year breakeven hit the Fed’s sweet spot of 2% in September but has climbed to 2.4% since then. Those numbers are not wildly higher than the Fed’s target, granted, but they’re directionally significant.

A surefooted economy aided by a mountain of fiscal and monetary stimulus is less a recipe for a weak labor market and more the makings of an inflation rate that is stubbornly higher than the Fed’s target. That may explain why the two-year doesn’t see the Fed lowering rates much further.

Keep an eye on that two-year yield. It’s likely to tell investors more about where the Fed is headed than anything the central bank or its Chair Jerome Powell say on Thursday.