Falling Oil Shifts Breakevens, but it Doesn’t Help the Fed

Falling Oil Shifts Breakevens, but it Doesn't Help the Fed

Abstract:

• Oil and inflation breakevens have fallen over the past month, but Fed Funds futures continue to climb.
• These signals do not conflict - they reference different cues. Oil is a price level move, not a demand move: A 30% drop in oil mechanically pushes headline CPI lower over the next year. This is merely math rather than a verdict on the economy.
• The breakeven curve itself backs this up: 1-year breakevens dropped ~113 basis points while 10-year breakevens only fell 21 basis points in the last month. That points to a near-term price story rolling through the curve, rather than an expectation of structurally lower inflation persisting.
• Futures were already leaning hawkish and will remain hawkish as long as core PCE stays hot. Even as oil prices ease, the market can price out cuts and float a possible hike on sticky core inflation and a resilient labor market. A cheaper barrel of oil doesn't undo inflation pressures on its own.
• There are several near-term drivers of core PCE worth monitoring as the year progresses. Most notably, core services PCE has averaged nearly 3.5% year over year for the last three months. This is well above the Fed's target and may force the conversation increasingly hawkish in the final four Fed meetings of the year.

Oil is down almost 30% over the past month, and inflation breakevens have fallen right along with it. Yet, Fed Funds futures have only moved in the direction of future hikes. If inflation expectations are dropping, some may ask why rate-cut expectations are not dropping as well. The reason for that comes down to variations in inflation gauges. Breakeven inflation is based on the yield differential between TIPS, which track headline CPI, and nominal treasuries. The CPI index gives energy a meaningful weight, and thus, when oil prices move, so do breakeven inflation expectations. The Fed, on the other hand, targets core PCE, which strips out energy. So when oil drops 30%, it pulls down headline CPI (and breakevens with it), but it barely touches the inflation number that is actually used by the Fed. The market and the Fed are simply looking at two different rulers.

Oil is Battering Around the Bond Market, But Means Little for the Fed

The oil drop naturally is a price level move, not a demand move. Just like the rise in oil this past spring elevated headline inflation prints and breakeven inflation rates, the 30% drop in oil pushed near- term breakevens and headline CPI forecasts lower. This is not a verdict on the economy, but merely math. Breakevens may follow the math, but the Fed follows economic cues. The policymaking body has said for years that it looks through swings in oil prices, particularly when those swings are supply-based. Though oil prices are falling now as prospects for peace in the Middle East rise, cheaper gas doesn't directly translate into lower services, wages, or shelter costs. The breakeven curve itself supports this. One-year breakevens dropped about 113 basis points, while ten-year break-evens only dropped about 21 over the last month. The bulk of the move has been a near-term oil price story working its way through the curve, not a sign the market expects structurally lower inflation for the longer term.

Herein lies the rub - looking through the distraction of the wild swing in oil prices, there appears to be some budding core inflation pressure, and that has resulted in a shifting Fed Funds futures curve. Futures were leaning hawkish before oil prices started to ease and have only continued to lean in that direction, as markets were caught off guard by inflation pressures that have emerged outside of the oil complex. At the start of this year, the futures market was anticipating two cuts from the Fed this year and was still anticipating two cuts by year's end when the war in the Middle East began. However, by the start of June, the futures market had priced out cuts and even floated a possible hike. This is not because oil prices were higher, but because of sticky core inflation and a resilient labor market. A cheaper barrel of oil doesn't undo these inflation pressures, especially if the oil price move is primarily a supply story (OPEC+ output, fading geopolitical risk premium) rather than a sign of weak global demand. Supply-driven disinflation is good news without being bad news for growth, which means it doesn't give the Fed a reason to cut.

Core PCE is Flashing Warning Signs for the Fed

All of this tells us that the real swing factor for Fed expectations isn't oil, or even near-term inflation breakevens as priced in the bond market - it's what actually moves core inflation, primarily represented by the Fed's preferred measure - PCE. In recent months, core PCE has accelerated from 3.0% in late February to 3.3%, and private sector economists as well as the Fed see reason to expect continued acceleration in the near term. Private sector economists surveyed by Bloomberg expect 3.2% core PCE inflation this year, up from their 2.7% forecast at the start of the year. The Fed's own economic projections have moved from an expectation of 2.4% core PCE for 2026 to 3.3% over that time. These levels are well above the Fed's inflation target of 2%, and if they persist, may force the hand of the Fed to hike rates, even as bond market implied inflation breakevens are moderating with the price of oil.

While many are hopeful that technology can reduce core inflation pressures, real time inflation figures are showing a lack of evidence of such deflationary pressure so far. This week's inflation print should be telling, economists are anticipating core PCE to rise to 3.3%, its highest level since November 2023, and the measure's 4th consecutive month over 3%. Notably, core PCE has been above 2.5% since April 2021, an uncomfortably long stretch above the Fed's target of 2%.

There are several near-term drivers of core PCE worth monitoring as the year progresses, as they will likely have heavy sway in determining the Fed's policy rate decisions in the final four months of the year. Datacenter spending is running at a pace that's pushing up electricity demand, construction costs, and skilled labor wages in markets where buildouts are concentrated, and that shows up in core services. Core services PCE is has averaged nearly 3.5% year over year for the last three months. Meanwhile, tariff pass-through is another live addition to inflation pressure: cost increases have been working their way into core goods prices in stages as pre-tariff inventory gets drawn down, so there's still room for that to add to or subtract from core PCE depending on how contracts reset. On the other side of the coin, shelter and rent disinflation has been the most reliable source of relief in core services, so a stall or reversal there would matter as much as anything happening in commodities. Any of these could contribute heavily to Fed expectations, not because they affect the price at the pump, but because they affect PCE - the price index that the Fed actually targets.

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