The hard data on inflation points to a modestly accelerating rate of inflation, a trend that supports the Federal Reserve’s ongoing policy of gently but consistently raising interest rates. The main push-back to that narrative is the Treasury market.

On two fronts, Treasuries are pricing in expectations that the recent rise in inflation has peaked (or at least will remain more or less stable at current levels). One source for this view is the lower spread for nominal less inflation-indexed Treasury yields, widely seen as the market’s implied inflation forecast. The softer outlook on pricing pressure is pronounced for the 5-year maturities: the yield difference has fallen below 2.0% recently after reaching as high as 2.16% in the spring.

Meanwhile, the yield curve has been flattening this year, another trend that some analysts see as a sign that inflationary pressure is waning. St. Louis Fed President James Bullard subscribes to this theory, as he said in a speech this week. “The flattening yield curve and subdued market-based inflation expectations suggest that the current monetary policy stance is already neutral or possibly somewhat restrictive.” He recommended that

US monetary policymakers should put more weight than usual on financial market signals in the current macroeconomic environment due to the breakdown of the empirical Phillips curve. Handled properly, current financial market information can provide the basis for a better forward-looking monetary policy strategy.

To the extent that Bullard’s analysis is accurate, the narrowing yield curve also appears to be signaling that inflation has peaked. Indeed, two widely measures of the yield curve – the spreads on the 10-year and 2-year Treasury yields and the 10-year and 3-month rates – have fallen to post-recession lows recently. If and when the spreads go negative, the slide would be seen as a recession warning, which in turn implies a disinflationary (and perhaps deflationary) environment.

Policy hawks counter that official inflation gauges are trending higher and that economic activity has strengthened. For example, the core rate price changes via the personal-consumption-expenditures price index, which is closely followed by the Fed, rose 2.0% on a year-over-year basis in July – the first time in six years that this gauge has matched the central bank’s 2.0% inflation target.

Economic output has picked up lately, too. GDP growth in the second quarter increased by a 4.2% rate (seasonally adjusted annual rate). The latest nowcasts for the third quarter reflect a range of expectations, but most still see a solid case for a healthy expansion in the near future. Today’s update of Now-casting.com’s Q3 estimate, for example, is 3.3%.

The question is whether the next round of inflation data will validate the Treasury market’s forecast for softer pricing pressure? The first clue arrives next Thursday (September 13) with the release of consumer prices for August.

One line of analysis says the Treasury market’s pricing should be viewed skeptically these days. The combination of extraordinary monetary policy decisions over the past decade and an unusually strong global appetite for safe havens have distorted the yield signals for US government securities.

In any case, Fed funds futures are pricing in a near-certainty that the central bank will continue lifting rates at the policy decision on September 26. CME data this morning points to a 99% probability that the target Fed funds rate will edge up 25 basis points to a 2.0%-to-2.25% range.

Note, however, that Fed Chairman Jerome Powell a few weeks ago said that “while inflation has recently moved up near 2%, we have seen no clear sign of an acceleration above 2%, and there does not seem to be an elevated risk of overheating.”

The Treasury market seems to agree. Will the incoming inflation reports offer confirmation? If so, the rationale for more policy tightening will be subject to renewed scrutiny and debate.

Alternatively, if the official inflation data continues to reflect accelerating pricing pressure, the Treasury market will be in line for an attitude adjustment.

Either way, the stakes are higher than usual for next week’s August update on consumer prices as the crowd prepares for the upcoming FOMC meeting and revisits assumptions about the inflation outlook.