Will US Inflation Breakevens Decouple From Oil Prices?

US inflation expectations from the fixed-income market typically track crude oil prices. Recently, however, the 5-year TIPS breakeven inflation rate (inflation expectations) has risen despite tame crude prices. Are we witnessing a short-term aberration or the beginning of a lasting divergence between these two?

To begin, medium- and long-term inflation expectations should not correlate tightly with oil prices. In a service-based economy such as the US, the medium- and long-term trajectory for inflation is contingent on price dynamics in the services sector. The latter is driven by wage growth, specifically unit labor costs. That is why the Fed targets core CPI (excluding food and energy) and is even de-emphasizing goods inflation, instead focusing on core services and wages.

Some of the US growth and inflation data have recently exceeded expectations. Plus, although wage growth is moderating, it is not yet consistent with the Fed's 2% core inflation target. These developments could have triggered an increase in US inflation breakevens, despite subdued oil prices.

If TIPS inflation breakevens continue moving higher, the Fed's willingness to pause will diminish.  Also, an increase in the TIPS breakeven inflation rate despite restrained oil prices would be a major alarm for the Fed, and its hawkishness will intensify materially. The rationale will be that the decoupling of inflation expectations from crude prices would signify that US inflation pressures are broadening.

Investors should watch the relationship between the US TIPS breakeven inflation rate and oil prices for clues about a potential hawkish shift by the Fed.