Inflation Expectations, Interest Rate Volatility, and Considerations for Funding

Inflation Backdrop: Above Target Inflation

Even before Operation Epic Fury began, inflation remained stubbornly above the Federal Open Market Committee’s (FOMC’s) 2% target. The most recent Consumer Price Index (CPI) and Core Personal Consumption Expenditures (PCE) data printed at 2.4% and 3.1%, respectively. The Fed’s target of a 2% annualized inflation rate in Core PCE has not been seen since early 2021. Along with realized inflation, survey-based measures of inflation expectations have consistently printed above levels seen before the COVID pandemic.

In 2025, the FOMC expressed limited concern about the above-target prints, noting that the one-time impact of tariffs pushed overall inflation levels higher and would soon abate. There was decent statistical support for that viewpoint, as the sectors most impacted by tariffs experienced an outsized increase in inflation pressure in the middle of 2025.

Recent prints, however, provide less support for the theory that sustained inflation is primarily due to the impact of tariffs. As has been the case for most of modern U.S. economic history, inflation pressure from services has remained above inflation pressure from goods. In recent months, inflation pressure from goods has declined somewhat, but inflation pressure from services, which are less directly impacted by tariffs, has persisted.

Also of note: traditionally, PCE has printed somewhat below CPI, due in part to the composition of the two indices. In recent months, PCE has printed above CPI. In CPI, inflation in the energy sector is weighted more heavily than in PCE, so it is possible that CPI will move closer to PCE in the coming months.

Operation Epic Fury: Widening in TIPS-Implied Breakevens and Higher Interest Rates

Since the invasion of Iran, global oil prices have experienced material volatility and increased notably. Although energy comprises only 6% of CPI, changes in oil prices have an outsized impact on overall inflation because energy is an input directly or indirectly to the production of most goods and services.

TIPS-implied breakevens, which are highly correlated with oil prices, measure the spread between TIPS and nominal Treasury securities (nominals). Although they are affected by the relative liquidity profiles of TIPS and nominals, TIPS-implied breakevens provide a market-based, timely proxy for inflation expectations.

So far this month, the five-year and 10-year TIPS-implied breakevens have increased about 20 and 15 basis points, respectively. At the same time, Treasury yields have moved higher across the curve. The price action is most pronounced at the front end, and the two-year Treasury yield has moved up about 30 basis points.

At the March FOMC meeting, Federal Reserve Chairman Jerome Powell suggested the FOMC was more focused on monitoring disinflation as the one-off price effects from tariffs abate than overreacting to changes in market-based measures of inflation expectations. Nonetheless, the Summary of Economic Projections indicated increased inflation expectations for 2026 and 2027, and Powell acknowledged that several members of the FOMC would like to reintroduce the possibility of interest-rate hikes into the distribution of potential outcomes for rates.

Supply-Side Inflation: Lower Loan Demand

To understand the likely impact of inflation on the economy and depository balance sheets, it’s important to differentiate between supply-side inflation and demand-side inflation. Demand-side inflation, like the inflation we saw in 2022, typically coincides with strong economic growth and consumer strength, and is often accompanied by increased loan demand. In this type of inflation, depository institutions face higher funding costs that accompany higher interest rates, a steeper curve, and a compelling net interest margin, allowing them to be more discerning in loan issuance.

Should the spike in oil prices translate to higher inflation, we will be experiencing a supply-side inflation shock. In a supply-side inflation shock, there is typically not an increase in loan demand to accompany the rise in interest rates, as the fundamental driver of inflation is detached from consumer strength. In the weeks since Operation Epic Fury began, credit spreads on investment-grade credit have only widened modestly, and price action has been concentrated in energy and energy-sensitive sectors. This suggests that the market is not pricing a material economic downturn as a result of the shock, but it also means credit spreads remain quite tight by historical standards, and that buying fixed-income assets may not be a compelling value proposition.

Considerations for Depositories: Build a Wider Probability Distribution

Banks and credit unions should reconsider the probability distributions for interest-rate outcomes that defined their strategies at the start of 2026 to ensure they still make sense given current market pricing.

Prior to Operation Epic Fury, the market was pricing several rate cuts into the curve this year, but those cuts have been priced out. Banks and credit unions should reconsider the probability distributions for interest-rate outcomes that defined their strategies at the start of 2026 to ensure they still make sense given current market pricing.

Banks and credit unions that expected to pass on lower interest rates through interest-bearing deposits may consider whether they still expect those interest rate cuts to materialize. Indeed, while it’s not a base case, it may be worth considering what your balance sheet will look like if rate hikes materialize.

For institutions that find their strategy no longer makes sense given recent moves in interest rates, it may be appropriate to review the cost of FHLBank Boston advances relative to the rate you pay on marginal deposits. In some cases, FHLBank Boston advances may offer the most financially attractive and customizable funding source.

Additionally, it may be appropriate to review your institution’s duration risk and ensure it aligns with your intentions. Depending on your specific profile, extending funding through longer structures may be prudent. FHLBank Boston’s floating-rate advances could also reduce your risk in the event of material interest-rate changes. Lastly, FHLBank Boston offers option-embedded advances, including putable (member sells the option to FHLBank Boston, resulting in lower funding costs) and callable (member owns the option, providing control to efficiently reduce wholesale funding reliance if needed) alternatives, that provide tools for members to tailor their own duration risk profile and hedge against tail risks.

Considerations for Depositories: Manage Higher Interest-Rate Volatility

Separate from interest-rate levels, another important factor to consider in managing the balance sheet is interest-rate volatility. Interest-rate volatility remains lower than the elevated levels observed in 2022, but it has increased in recent weeks.

Institutions with material exposure to floating-rate instruments tend to do well when interest rate volatility increases. In contrast, institutions with material exposure to fixed-rate mortgages may underperform (particularly those struggling to manage mortgage loans issued before the most recent Fed hiking cycle). Higher volatility can also create favorable entry points for the addition of certain assets and liabilities, such as mortgage-backed securities and putable advances, where higher volatility leads to wider spreads.

If your institution is concerned about its exposure to fixed-rate mortgages, it could consider selling mortgages to FHLBank Boston through the Mortgage Partnership Finance® (MPF®) Program. The MPF Program allows a member to sell a mortgage to FHLBank Boston, but retain some credit risk in the asset, for which the member is compensated. In this environment, it might allow an institution to tailor its exposure to convexity risk.