The Inflation Cut

There are expectations in the markets of CPI reaching over 3 percent, with core closer to 3.5%. The tariff pass-through may have faded somewhat, but earnings season revealed that the number of times inflation was mentioned over tariffs was 2:1.

In other words, after passing through tariffs, companies expect inflation, especially those impacted, which raised their year-ahead price growth by 0.7 percent, according to the Atlanta Fed.

The market has priced this jump—0.7 percent — into 1Y inflation swaps, and CPI swaps (derivatives that price CPI releases) for the next 3 months. While rate cuts have increased in number (also a 0.7 change compared to pre-non-farm payrolls), the total expected for 2025 is lower than in April (Figure 1).

Markets still view the Fed remaining restrictive, even though there is a 10-20 percent chance of a 50-basis-point rate cut. Yet, the rate cut on September 17 has inflation risk written on it because short-term inflation expectations have not eased.

If the Fed presses on, short-term real interest rates could move closer to zero, fueling dollar weakness, inflation, and independence concerns.

Figure 1: Number of cuts in 2025 and CPI expectations by year-end (%)

Source: BLS, DTCC, CME

Globally, the US (and Japan) stand out. The inflation swap curve—inflation derivatives by maturity—is inverted for the US and Japan, but in an entirely different shape for the UK, Eurozone, and a few other countries (Figure 2).

Inflation risk remains priced in the US, which contrasts with the move in nominal Treasury yields over the last three months, with 2Y yields down by 50 basis points, but 10Y yields notably down by almost the same amount, 40 basis points.

While that displays a modest bullish steepening of the yield curve, the move down in yields is more parallel, signifying a level of uncertainty about the inflation backdrop, especially uncertainty about the Fed being able to maintain a 2 percent inflation target.

Figure 2: Inflation swap curves (%)

Source: CME

To that effect, markets are pricing a more consistent 3 percent target zone post Liberation Day. The CPI swaps are in a 3 to 3.4 percent range, and the NowCast (real-time estimate) is also trending towards 3 percent (Figure 3).

As noted previously, other online and digital real-time measures of inflation, such as TruFlation, InflataCart, Acktowiz grocery price board, and Adobe Digital price index, are in a 2 to 3 percent range, with the NY Fed 1Y inflation expectations survey released today likely over a 3 percent reading.

Figure 3: CPI at 3 percent in the future (Y/Y, %)

Source: Cleveland Fed, BLS, DTCC

If 3 percent is now the accepted norm by markets and consumers, the Fed will likely (implicitly) follow through at some point, as the revision of the framework revealed at Jackson Hole appears to imply. For US Treasuries, there is not a sufficient risk premium priced in, and the yield curve is too flat compared to other countries (Figure 4).

While a future steepening may entail 100 to 150 basis points of rate cuts over the coming year, as Waller indicated, long-maturity Treasuries will reckon with a more permanent 3 percent inflation.

Figure 4: US yield curve too flat vs. peers (2Y/30Y, bps)

Source: MoF, Tresor, US Treasury