• Bank of America says 5Y5Y forward inflation expectations are now the key gauge of Fed credibility.
  • Recent gains in forward breakevens signal waning confidence in the Fed, though levels remain within historical ranges.
  • BofA still expects the Fed to begin raising rates in September.

A Credibility Check

Bank of America has identified the 5-year/5-year forward inflation expectation as the primary metric by which markets judge the Federal Reserve's credibility. According to a note released Thursday, the recent rise in forward breakevens reflects a growing skepticism about the Fed's commitment to its inflation-fighting rhetoric. However, the bank is quick to point out that these levels are not yet alarming, staying within the range seen over the past decade.

"The market is beginning to question whether the Fed will walk the walk," said a BofA strategist, speaking on condition of anonymity. "But we're not at a tipping point; it's more of a slow erosion of confidence."

Market Moves

The 5Y5Y forward breakeven, which measures the average expected inflation over the five-year period that begins five years from now, has climbed by X basis points this week to Y%. This move mirrors a broader uptick in inflation compensation across tenors, as traders adjust their expectations for the path of monetary policy.

"Investors are re-pricing the odds of a prolonged period of accommodation," said another market participant. "Every data point that surprises to the upside adds fuel to the fire."

Fed's Next Move

Despite the creeping doubts, BofA maintains its forecast that the Federal Reserve will initiate its first rate hike in September. The bank's economists argue that the central bank remains focused on achieving maximum employment and will tolerate a temporary overshoot in inflation.

"We believe the Fed is committed to its new framework, which allows for inflation to run moderately above target for some time," the note said. "The September liftoff is still our base case."

Implications

A sustained rise in longer-term inflation expectations could force the Fed's hand, potentially leading to an earlier or more aggressive tightening cycle. This would have broad implications for borrowing costs, asset valuations, and the overall economic recovery.

Analysts will be watching the upcoming consumer price index report and the Federal Reserve's preferred inflation gauge, the PCE deflator, for further clues. Any significant deviation from forecasts could accelerate the shift in credibility dynamics.

Looking Ahead

While BofA's assessment provides a snapshot of current sentiment, the situation remains fluid. The Fed's communication in the coming weeks will be crucial in determining whether these inflation expectations continue to drift higher or stabilize.

As one strategist put it, "The Fed has a delicate balance to strike. They want to reassure markets without committing to a specific timeline. The 5Y5Y is the canary in the coal mine, and right now, it's singing a slightly more nervous tune."