New York Fed President William Dudley is inclined to ignore the recent drop in inflation forecasts via the Treasury market. In a speech last week, he explained that “in assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures.” The distinction is more than academic. “Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored,” he noted. Market-based estimates, however, tell a different story.

The yield spread for a nominal 10-year Treasury less its inflation-indexed counterpart dipped to a three-year low yesterday (Nov. 18). Mr. Market’s inflation estimate is now a slim 1.84% — down from nearly 2.30% as recently as this past July. Surveys may reflect a well-anchored outlook for inflation, but the Treasury market seems to be anticipating a stronger run of disinflationary momentum.

The slide in inflation expectations comes at a time when the Federal Reserve is signaling that it’s still planning to raise interest rates at some point next year. Although Treasury yields have climbed in recent weeks after last month’s stumble, the overall trend for the year still reflects a downward bias. The benchmark 10-year yield yesterday (Nov. 18) settled at 2.32%, down from 3.04% at last year’s close.

It’s the new conundrum: falling yields and lower market-based inflation expectations in the face of expectations for a rate hike in the near term. It’s an odd situation, and it comes with a fair amount of risk. As Bloomberg observes:

The stakes are higher this time because rates are lower and the yield curve is flatter. Raising short-term rates in the face of stable or falling long-term rates could lead to a situation where the Fed “quickly inverts the yield curve and turns credit creation on its head,” said Tim Duy, an economics professor at the University of Oregon in Eugene and a former U.S. Treasury Department economist.
An inverted yield curve occurs when short-term securities yield more than longer-dated bonds. That discourages banks from extending credit because they finance long-term loans with short-term debt. Inverted yield curves typically precede recessions.
Duy said the Fed has few options if long rates don’t rise after increases in the federal funds rate: the Fed would have little scope to raise the benchmark further, and not much room to cut if the economy were to slump.
“I’m sort of wondering, what’s the game plan here,” Duy said.