Breakeven Inflation Rates: What’s Beyond the Post‑Election Bump?

The response of inflation-related markets to U.S. President-elect Donald Trump’s potential (if still murky) policy agenda has been dramatic. Breakeven inflation rates (the spread between Treasury Inflation-Protected Securities (TIPS) and nominal Treasuries of equivalent maturities) have risen significantly since Election Day on 8 November.

In our view, the move mostly reflects a sudden rise in the probability of higher inflationary macroeconomic outcomes. We believe the market’s reaction supports our previous assertion that low breakeven inflation rates in 2014–2015 were driven by shifting inflation expectations – and not an increase in the relative liquidity of TIPS, as some Federal Reserve officials have stated.

Overall, we agree with the market-implied view of Trump’s policies: specifically, that fiscal expansion at a point in the business cycle when labor market slack is relatively low, coupled with immigration policies that could slow labor force growth, is a recipe for higher inflation. Of course, we believe the Fed will ultimately push back against any significant and persistent overshoot of its 2% inflation target. Still, these policies plus increasing questions about central bank independence under a Trump presidency and some potential for a disruptive trade war suggest a bias toward higher inflation among the distribution of possible outcomes, in our view.

Markets are not fully discounting higher inflationary outcomes

Expectations are critical: For example, we believe the historically low TIPS breakeven inflation rates in 2014–2015 were mostly a consequence of a change in the distribution of expected inflationary outcomes. The declines in long-term inflation compensation in 2014 and 2015, as measured by five-year forward, five-year breakeven rates, coincided with falling nominal yields and declines in the market-implied probability of materially higher inflation (see charts 1 and 2).