Inflation and the Fed rate
Lesson 2 of 12 in the course “Analytics”. Free, with animations and a quiz.
Why everyone waits for CPI
Inflation is rising prices: the same shopping costs more. The Fed, the US central bank, fights it with its interest rate, meaning the price of borrowing money. High inflation: the rate stays high, money gets expensive, and risky assets like stocks and crypto struggle. That is why the day CPI, the US consumer price index, comes out is one of the most nervous days of the month. Even for bitcoin.
CPI, core CPI and PCE
CPI is calculated from a basket of goods and services people buy. "y/y" means year over year: how much higher prices are than 12 months ago. Core CPI: the same without food and energy, because their prices jump too much. PCE: another price index, based on what people spend. The Fed's 2% per year target is set on PCE. Core PCE: PCE without food and energy.
Breakeven: what the market expects
A bond yield is the yearly percent the buyer of that bond earns. The 10-year breakeven is the inflation the bond market builds in for the next 10 years. The math: the yield on a regular 10-year US bond minus the yield on the same bond protected from inflation (TIPS). Example: 4.3% − 2.0% = 2.3%. So the market expects about 2.3% inflation a year on average. It is an expectation, not a fact.
Example: reading CPI m/m
"m/m" means month over month. Example: CPI m/m is 0.2%. If that pace holds for 12 months, you get about 2.4% a year (1.002 to the 12th power ≈ 1.024). That is close to the 2% target. But 0.4% a month is already about 5% a year. So above 0.3% m/m is often seen as a warning, a rule of thumb. The monthly number shows a turn sooner: the yearly one still contains old months.
The Fed rate and risky assets
The Fed rate (fed funds) is the percent US banks charge each other to lend money overnight. Inflation above target: the Fed raises the rate or keeps it high. Economy weakening, inflation lower: it cuts. A high rate makes loans pricier, while savings and bonds pay more. Some money leaves stocks and crypto. This is logic, not a law: the market often reacts in advance.
FOMC and rate futures
The FOMC is the Fed committee that decides what to do with the rate. It meets 8 times a year on a schedule, and those are the meetings. A rate future is a contract whose price depends on what the average rate will be in a given month. If futures prices show the market expects a rate below today's, it is pricing in a cut. The odds are calculated from these prices.
The Fed roadmap
Fed decision odds are not made up: they are calculated from the prices of 30-day fed funds futures on the CME exchange, the same way the well-known CME FedWatch works. Example from the picture: 85% no change, 15% for a cut. Read it as: the market mostly bets on a pause right now, but can change its mind after new data. Your move: before a meeting, guess the decision yourself and compare with the market.
Where to see charts for free
All these indexes are free. The original source is FRED, the open database of the St. Louis Fed. Every indicator there has a code, for example CPIAUCSL for CPI or PCEPI for PCE, and you can always use it to check a number from the news. Look at charts covering several years: one point says nothing, the slope of the line matters. It is easiest when CPI, core, PCE and breakeven sit on one page with "what it is and how to read it" notes.
Mistakes: forecast, fact, "priced in"
What moves the market is not the number itself but the gap from expectations, meaning the average analyst forecast. Example: expected 0.3%, actual 0.3%. It is all "priced in", meaning built into the price in advance, so little movement. Expected 0.2%, actual 0.4%: a surprise, a strong reaction. Second mistake: looking only at headline CPI when gasoline is pushing it while core is calm.
Check yourself
- How do you read 0.4% for the month?
Correct answer: Worrying: annualised it is about 5%. You turn the monthly pace into a yearly one: 1.004 to the 12th power ≈ 1.049, so about 5% a year. That is more than double the target, so the market will see it as a reason to keep rates high. - Which index is the Fed's 2% target based on?
Correct answer: PCE, the index of prices for what people spend on. The 2% target is officially set on PCE. CPI comes out a couple of weeks earlier, so the market reacts to it first, but the Fed's main guide is PCE, especially core PCE without food and energy. - Which market reaction is more likely?
Correct answer: A weak one: it was already priced in. Price is moved by surprise, the gap between the fact and the expectation. When the number matches the consensus, traders have already built it into the price, so there is usually no big move. Not an iron rule: the market can react to details inside the report. - What do these 70% mean?
Correct answer: The market's expectation, which can still change. The number comes from rate futures prices: it is the traders' collective bet. New inflation or jobs data can shift it within a day, so you watch how the odds change over time.